The Hidden Gem Within Your 401k
The Internet puts a wealth of information at our fingertips, but that’s not always a good thing. For example, Google “retirement statistics” and you’ll see this dubious list of results:
At CWM, we strongly reject the notion that the very concept of retirement savings is terrifying, jaw-dropping or frightening—and it certainly shouldn’t “scare the crap of you.” On the contrary, it is fulfilling to tell a client, “Go for it—retire. You’re ready.” That’s our ultimate goal when partnering with you as your financial planner: to help you achieve your idea of living richly.
This article provides an overview of retirement saving strategies, particularly when utilizing 401(k) plans—including a hidden gem that can enable you to save thousands more toward your retirement. By arming yourself with knowledge, you’ll help position yourself to defy those “terrifying” retirement statistics.
Traditional vs. Roth 401(k)
Nearly 79% of Americans work for employers that offer 401(k) plans1, which allow employees to contribute pre-tax dollars directly from their paycheck into their retirement funds. Many see the pre-tax contributions as a key advantage of using a 401(k) to save for retirement, since doing so lowers their annual taxable incomes.
But what if you’d rather pay taxes on your total income now, if you expect your tax bracket to increase by the time you’ll be taking 401(k) distributions? To avoid paying more taxes later, another option to consider (if available) is the Roth 401(k). With this plan, you can contribute funds on a post-tax elective deferral basis, in addition to or instead of pre-tax elective deferrals under a traditional 401(k) plan.
The critical difference here is that the income contributed to the Roth 401(k) is taxable in the year it is earned, in contrast to traditional 401(k) plans, in which the income is taxable in the year the funds are distributed. This option may be ideal for younger professionals who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket by the time they retire.
The “Max-Out” Gap
Regardless of which 401(k) option you choose, the maximum amount you’re able to contribute per year is $19,000 ($25,000 if you're 50+). The total allowed contribution—including any employer match—is $56,000, or $62,000 for those 50+. So unless your employer match results in at least $37,000, it’s very likely that you will not be meeting that $56,000 maximum threshold.
Take Bob, in this hypothetical example. Bob is 49 and has a well-paying job at Boeing, a company whose Voluntary Investment Plan (VIP) provides a 75% match on 401(k) contributions up to 8% of his salary. He makes $175,000 per year and contributes the full $19,000 to his 401(k) annually, which results in a $14,250 match from Boeing. Between the contribution and the match, Bob will add $33,250 to his traditional 401(k) plan this year—which leaves a nearly $23,000 gap between his contributions and the maximum limit of $56,000.
With Bob’s income being so high, he has plenty of room to contribute more—if his budget allows him to. But how can he get there?
Stars Align for Back-Door Roth Conversions
In 2010, the federal government removed the income limit on Roth IRA conversions; four years later, the IRS issued a private letter ruling on back-door conversions. Together, these rulings unlocked incredible potential for a third 401(k) plan option: enter the “hidden gem” of the in-plan ROTH conversion, also known as the mega back-door Roth conversion strategy.
Using this strategy, if his employer plan allows for after-tax contributions to be made, Bob can now take an extra $22,750 from his annual salary and make an after-tax contribution to his 401(k). Then, he’ll convert those dollars into a Roth. He won’t get a deduction on this contribution, since it was made on an after-tax basis and is not going into a Roth 401(k). Instead, the $22,750 is going into an entirely new “after-tax bucket” within his existing 401(k) plan.
Since Bob did not receive a deduction on his contributions to the after-tax bucket, when he does convert those after-tax dollars to his Roth taxes will not be due, he will only pay taxes on any growth that accumulated between the time he contributed and the conversion.
It’s a great deal, if you ask me: the addition of the mega back-door Roth conversion feature will allow Bob to take full advantage of the deductible contributions and tax-free contributions, both of which may be really helpful someday when he’s retired and is drawing on these accounts. He can take some taxable income from his traditional 401k while supplementing his income from the Roth, which will be tax free— thus potentially allowing him to live like he is in a higher tax bracket than he is really in.
The beauty of this strategy is that once the dollars are in the Roth, he will never pay tax on this money in his lifetime and neither will his beneficiaries (assuming the tax laws don’t change). I don’t know about you, but I think tax rates are going up in the future, so this is a big home run for Bob.
Setting up Your 401(k) Plan for a Back-Door Roth Conversion
Since 2014, companies like Boeing, Microsoft, Google and Facebook have amended their 401(k) benefits plans to allow for mega back-door Roth conversions. Many other companies could easily adopt this retirement benefit, as well, but many employers (and employees) aren’t even aware of the option, since it’s still fairly new.
Once a company does decide to offer the back-door Roth conversion within its retirement benefits plan, all that’s required is that the plan administrator amends the “Plan Document.” Making the change is relatively simple, and the value it provides to employees can serve as a major competitive advantage, especially as employers compete for talent in today’s job market. For example, when we made this change here at CWM, our plan’s third party administrator charged a one-time fee only $200 in order to make an adjustment that will benefit all of our employees for years to come. (Keep in mind that costs may vary depending upon your plan’s administrator.)
If you have questions about how to make the most of your retirement planning strategy, please reach out to me directly. I’m happy to work with you to develop a plan that enables you to work toward your retirement and lifestyle goals.
1 Backman, Maurie. (June 19, 2017). Does the Average American Have a 401(k)? Motley Fool.
Comprehensive Wealth Management does not provide tax advice. This material is not intended to replace the advice of a qualified tax advisor. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situation are made.
There is no assurance that any strategy will achieve its objectives.
This is a hypothetical example to help better understand the concepts we’ve covered in this article. This is not intended to predict any retiree’s individual financial circumstances.
Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
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