Isn’t the IRS great?
Most people imagine the people at the IRS as stuffy, grey-suited, money-grubbing villains but I see things differently. I imagine a bunch of sexy, lab-coated fientists cooking up interesting ways to help us retire even earlier.
Since they are like us, they understand the enjoyment we get out of solving complex problems and they cater to our desire to prove our intelligence by setting convoluted rules and giving conflicting guidance.
Sometimes, however, when things are particularly fuzzy and even the best financial minds are unable to agree on an appropriate interpretation of the rules, they pat us on the back of the neck and say, “It’s all going to be okay.” September was one of those times.
Mega Backdoor Roth
People have been asking me about something often referred to as a Mega Backdoor Roth. I spent quite a bit of time researching the strategy (which is described below) but since the IRS rules didn’t clearly give the green light, I decided not to write about it.
At the end of September, however, the IRS released Notice 2014-54. Not only did the notice clear up some of the questions I had but it also seemed to give the go-ahead for another excellent tax-avoidance strategy we can add to our ever-growing arsenal. This particular strategy could allow us to make an additional $35,000 in Roth IRA contributions ever year!
Before I dive into the strategy, some background info is required.
When contributing to a 401(k)/403(b), there are three different types of contributions that you can make:
The first type of contribution is a pre-tax contribution. If you have a normal 401(k), the amount that automatically gets contributed from your paycheck is a pre-tax contribution. The limit on the amount of pre-tax contributions you can make in 2015 is $18,000.
If your employer matches some of your contribution or puts any money into the account for you, these contributions are also pre-tax but do not affect the $18,000 annual personal limit.
Pre-tax contributions to a 401(k) are tax-free going in and they grow tax free but you have to pay tax on the money when you withdraw it at ordinary income tax rates.
If you have a Roth 401(k) instead, the contributions you make are considered Roth contributions.
Roth contributions are made with after-tax money (i.e. you paid tax on the money before putting it into the Roth) but the contributions are allowed to grow tax free and all principal and earnings can be withdrawn tax free when you reach standard retirement age.
The least-known type of contribution you can make is an after-tax contribution. After-tax contributions are made with money you’ve already paid tax on (like Roth contributions) and the contributions can grow tax-free (like both) but all growth will be taxed upon withdrawal.
Depending on how much your employer contributes to your retirement account, you could potentially contribute up to $35,000 extra into your 401(k) every year with after-tax contributions. The total 401(k) contribution limit for 2015 is $53,000 so to figure out how much in after-tax contributions you could make, simply subtract your pre-tax/Roth contributions and your employer contributions from $53,000. For example, if someone maxes out their 401(k) in 2015 and their employer contributes $6,000, the after-tax contribution limit would be $29,000 ($53,000 – $18,000 – $6,000 = $29,000).
So why are after-tax contributions suddenly a lot more appealing?
With Notice 2014-54, the IRS has stated that when transferring money from you 401(k) into your IRAs, you can easily divert the pre-tax portion of your 401(k) and all the investment growth to your Traditional IRA and the after-tax portion to your Roth IRA, without paying any tax.
This is a big deal for people who can make in-service distributions (i.e. 401(k)-to-IRA transfers while still employed) or those of us who plan to leave full-time our employer soon because this will allow us to dramatically boost our Roth IRA contributions!
Assume that you read my article on front-loading and on January 1st, 2015 you decide to max out your pre-tax 401(k) contributions, you convince your employer to contribute $6,000 immediately, and you max out your after-tax contributions as well (far fetched, I know, but it will make the example easier to understand).
Here’s what your 401(k) would look like on January 1st:
Next, assume you just leave it there and when you eventually leave your job, you find that the market has increased your 401(k) balance by 30%!
Here’s what your 401(k) would now look like:
Since all pre-tax contributions and all growth within the 401(k) will be taxed, here’s all the money that would be subject to tax once you decide to tap into the account:
As you can see, you don’t really have tax-free gains on the after-tax contributions, you have tax-deferred gains instead, since you’ll eventually have to pay tax on the money. Since those gains could have been taxed at lower long-term capital gains rates had they been invested in a normal taxable account but now they’ll be taxed as ordinary income instead, you can understand why you probably haven’t heard of after-tax contributions before.
Now that the options for after-tax contributions are much better, let’s take a look at a better way to handle the after-tax contributions.
Assume the same scenario but rather than leave everything in the 401(k) to grow, you instead immediately rollover your entire balance to two separate IRAs using an in-service withdrawal on January 2nd, 2015. According to the new guidance, the pre-tax contributions can go directly into a Traditional IRA and the after-tax contributions can go directly into a Roth IRA.
Here’s what your accounts would look like when you finally decide to take your money out:
You can see that the gains on the after-tax contributions that would have been taxed in the initial scenario are now protected in the Roth IRA and will be tax free whenever we decide to withdraw the money!
If you are already maxing out your pre-tax 401(k)/403(b) contributions (see this post for why I believe a pre-tax contributions are better than Roth contributions for future early retirees) and are also maxing out your IRA, you should check with your 401(k) custodian to see if you can start making after-tax contributions as well. Thanks to the new IRS guidance, making after-tax 401(k) contributions will effectively allow you to contribute up to $35,000 extra to your Roth IRA every year (in addition to the normal $5,500 IRA contribution limit)!
If you are able to perform in-service withdrawals, you can minimize the amount of growth that takes place before the conversion, which will shield even more of your money from taxes.
What do you think? Do you have the ability to make after-tax contributions? How about in-service withdrawals? Sadly, my plan doesn’t allow either so I won’t be able to take advantage of this incredible tax-avoidance strategy but hopefully many of you will.
The Ultimate Retirement Account
By using your Health Savings Account (HSA) intelligently, you can receive the best benefits of a Traditional IRA and a Roth IRA in one account!