Too good to be true? - after tax deductions to ROTH

[FireDreamer]

My employer recently added a benefit to our retirement plan which allows me to contribute after-tax dollars through payroll deductions. My understanding of this benefit is the IRS limit is 401K pre-tax + 401K ROTH + company match + new after-tax contribution cannot exceed $57K. Since I max out my 401K with pre-tax dollars, and estimate my company match to be around 8K, the max I can contribute to the after tax portion is 57K - 19K - 8K = 30K. The real benefit kicks in where these after-tax contributions are converted in-plan to a ROTH IRA as soon as they enter the account, so no/little tax penalty!

My wife and I earn too much to qualify for ROTH or traditional IRA tax benefits. This seems like a great way to gain access to ROTH with out income limits.

Since there's only 12 pay periods left, I elected to contribute a significant portion of my check to this after tax to ROTH account, leaving me with little money each week. I'm planning to use cash from previously sold company stock to compensate for the loss. Money is fungible after all!

Is this too good to be true? Are there lurking tax bombs here that I'm not considering?

 

[DINKFIRE]

My understanding is that you total contribution to both regular and Roth 401k together is limited to $19,000 total in 2019. You can contribute to an IRA or Roth IRA up to $6000 this year (with tax-deduction limit based on income, and backdoor conversion). If you are over 50, there's additional amount you can contribute. The total amount contributed to your 401K account is limited to $57K including your contributions, company match and any additional contribution by the company such as profit sharing.

 

[geeky_grrl]

This is often referred to as a mega backdoor Roth and is great since your company allows it and in service distributions.

When I was employed my company had that and I added a lot to my Roths that way. It was a little annoying at the time because I had to call for each distribution initially but it sounds like your plan is convenient. I love having all of that extra Roth money since that should help me manage my MAGI in retirement since there are no taxes on the Roth money as I withdraw (and I can pull the contributions before 59.5).

 

[DINKFIRE]

This is often referred to as a mega backdoor Roth and is great since your company allows it and in service distributions.

When I was employed my company had that and I added a lot to my Roths that way. It was a little annoying at the time because I had to call for each distribution initially but it sounds like your plan is convenient. I love having all of that extra Roth money since that should help me manage my MAGI in retirement since there are no taxes on the Roth money as I withdraw (and I can pull the contributions before 59.5).

This is a fantastic option, although none of my employers has ever offered one, but I'll definitely ask about this if I change job

 

[bada bing]

The "Mega-backdoor Roth" you are describing is well vetted at this point. The Roth IRA that is funded by the maneuver is no different than any other Roth created by conversion, with the same rules. I've been doing it for 6 years now. As you said "money is fungible" and if you have an employer plan that allows the mega-backdoor Roth, it is worth considering even if you don't have adequate payroll income to make the whole limit contribution but have other outside funds that can make up the budget shortfall. A lot of people I've discussed this with seem to get stuck on the idea that the contributions have to come out of payroll and don't get the "money is fungible" concept.

Even though you make enough to not qualify for pre-tax or direct Roth IRA contributions, don't overlook the possibility of regular "backdoor Roth" contributions. The annual IRA contribution limit is in addition to the qualified plan limits that govern the mega-backdoor Roth.

One additional nuance possible with the limits on a mega-backdoor Roth is what your employer's plan does with the match when you reach the annual funding limit of your 401K. My employer's plan still credits the match but directs it into a separate deferred compensation plan. That isn't typical, and every plan is different. You need to know what happens when plan limits are reached to best structure your payroll contributions through the year if you intend to approach annual limits.

 

[FireDreamer]

Even though you make enough to not qualify for pre-tax or direct Roth IRA contributions, don't overlook the possibility of regular "backdoor Roth" contributions. The annual IRA contribution limit is in addition to the qualified plan limits that govern the mega-backdoor Roth.

Is this where I contribute to a traditional IRA and convert it to a ROTH? I just learned of this and started doing it this year. I had $$ in both roll over IRA and several years of traditional IRAs (all contributions had no tax deductions associated). According to my accountant, I had to first transfer my roll-over IRA into my 401K, then convert my traditional IRA to a ROTH. It had to do with how the IRS considers the value of all IRAs for taxes; I don't recall the details.

I chose to convert now only because the gains were minimal in my traditional IRA now (even though I'll pay a higher tax rate). I'm assuming the total tax I pay now will be less than the total tax I pay after 15 or so years of growth even if the rate is lower.

One additional nuance possible with the limits on a mega-backdoor Roth is what your employer's plan does with the match when you reach the annual funding limit of your 401K. My employer's plan still credits the match but directs it into a separate deferred compensation plan. That isn't typical, and every plan is different. You need to know what happens when plan limits are reached to best structure your payroll contributions through the year if you intend to approach annual limits.

Interesting.. Are you saying, if I max out all contributions and reach the 57K limit, then my company match may be forfeited or redirected? I'll look into this - thanks for the tip!

 

[bada bing]

Is this where I contribute to a traditional IRA and convert it to a ROTH? I just learned of this and started doing it this year. I had $$ in both roll over IRA and several years of traditional IRAs (all contributions had no tax deductions associated). According to my accountant, I had to first transfer my roll-over IRA into my 401K, then convert my traditional IRA to a ROTH. It had to do with how the IRS considers the value of all IRAs for taxes; I don't recall the details.

I chose to convert now only because the gains were minimal in my traditional IRA now (even though I'll pay a higher tax rate). I'm assuming the total tax I pay now will be less than the total tax I pay after 15 or so years of growth even if the rate is lower.

You got it, that is what a "backdoor Roth" is. A minor point, which is in the past now for you, is the conversion of tIRA funds into your Roth IRA. The taxes are due on the whole amount, contributions and gains, for all funds that were not contributed after-tax. That is why many people choose to roll their existing tIRA balances into their 401K, to further defer paying taxes on those funds.

Another minor point: you should target having the most money to spend - after tax - in retirement. Not trying to minimize the amount of taxes paid. They sound the same, but they aren't. Taking an income tax deferral for a retirement contribution may wind up paying more taxes eventually because the money may grow so much. It still is a smart choice because the years of compounding benefit both the account holder and the tax man.

Interesting.. Are you saying, if I max out all contributions and reach the 57K limit, then my company match may be forfeited or redirected? I'll look into this - thanks for the tip!

Yes, there are potential pitfalls that are plan specific. Some plans do not "true up", which means they don't pay the match for paychecks that don't have at least the minimum contribution, regardless of total annual percentage contributed. For plans that don't true up, it is also possible they don't count after-tax contributions as qualifying for matching. You have to find out your plan specifics before scheduling your contribution types per paycheck. If your plan trues up, then you are fine as long as you make the minimum annual percentage contribution for the whole match.