I’m encouraged by the result of my anonymous poll on the availability of non-Roth after-tax contributions in your 401k or 403b plans. Indeed a good 40% of respondents reported having it available. It’s not that elusive after all.
This is really good news, because it’s a great avenue to lower your taxes and save more for retirement. Because this is available to more people than I originally thought, I’m going to write a few more articles on this topic. If you don’t have it available to you (myself included), I’m sorry you can only watch with envy. I hope you will run into it in the future.
As you recall from the previous article The Elusive Mega Backdoor Roth, most plans that allow non-Roth after-tax contributions also allow in-service distributions. In other words, they let you take out the non-Roth after-tax money and its earnings to a Roth IRA while you still work for the employer.
What if the plan doesn’t?
Some plans require you to keep the non-Roth after-tax money in the plan until you terminate or until you reach age 59-1/2, just like your pre-tax or Roth money. In that case it still can be a good idea to max out non-Roth after-tax contributions even if you have to wait until you change jobs. This is true especially when these days the median tenure is under 5 years.
I made a spreadsheet to model this. You make non-Roth after-tax contributions to your 401k or 403b. Then you wait until you change jobs. You pay taxes on the earnings as ordinary income when you roll over the money to a Roth IRA at that time. The remaining amount then grows tax free in the Roth IRA. How does it compare with just saving money in a regular taxable account and paying the lower tax rates on dividends and capital gains?
The spreadsheet shows that you still come out ahead with non-Roth after-tax contributions to your 401k or 403b followed by rolling over to a Roth IRA, as long as
- the investments in the plan aren’t too bad; and
- you are not trapped in the plan for too long relative to the number of years you will have the money grow tax free in a Roth IRA; and
- you actually use the money as opposed to donating it to charity or leaving it to heirs.
Here’s an example:
|Marginal Tax Rate At Time of 401k Distribution||40%|
|Capital Gains Tax Rate at Withdrawal||20%|
|Tax Rate on Dividends||20%|
|Extra Cost in 401k||1.0%|
|Number of Years In Plan Until Rollover to Roth IRA||5|
|Number of Years Until Withdrawal||30|
|End value in Roth IRA||$85,026|
|End value in taxable after paying capital gains taxes||$77,390|
I included 5% for state income tax; that’s why the tax rates on dividends and capital gains are 20%, not 15%. A non-Roth after-tax contribution of $10,000 will grow into $85,026 after staying in the 401k plan for 5 years plus another 25 years in a Roth IRA. The same investment in a taxable account will grow into $77,390 in 30 years after paying all the taxes on dividends and capital gains. Making the non-Roth after-tax contribution comes out 10% more.
This calculation is conservative in that it pays taxes on the earnings from the 401k distribution when it’s rolled over to a Roth IRA. If we assume taxes will be deferred by doing a split rollover (earnings go to a traditional IRA), the advantage would be larger.
Also note if you expect to leave in 5 years or if you will reach 59-1/2 by then, your first year’s contribution will be in the plan for 5 years and your last year’s contribution will be in the plan for only 1 year. On average your contributions are in the plan for only 3 years. Changing the number of years in the plan from 5 to 3 increases the advantage from 10% to 17%.
Of course it would be better if you don’t have to wait. Under the same assumptions but changing the time in the plan to half a year, which is the average wait time if you spread out your contributions and you request a distribution once a year, the advantage becomes 28%.
You can enter different assumptions and see how it comes out for your specific scenario. Here’s the link to the online spreadsheet:
If you are among the 40% who have access to non-Roth after-tax contributions in your 401k or 403b plan, take full advantage! Don’t let the opportunity go wasted even if you have to wait until you change jobs before you roll it over to your Roth IRA.
For more on mega backdoor Roth, please read:
- The Elusive Mega Backdoor Roth
- Mega Backdoor Roth Without a Big Paycheck
- Mega Backdoor Roth and Access To Your Money Before 59-1/2
- Mega Backdoor Roth In Solo 401k: Control Your Own Destiny
[Photo credit: Flickr user Neveen]