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% |
| Investment Return | 8.0% |
| Dividend Distributions | 2.0% |
| 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:
Spreadsheet: Mega Backdoor Roth Without In-Service Distribution
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]
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Eric says
I have a question on the statement in the article:
“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.”
Didn’t a recent IRS ruling (sept 18, 2104) state that you can roll the pretax to Roth and roll the earnings to a regular IRA with no tax implications ?
See
http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/
Eric says
Sorry, I see you addressed tis with the statement :
“If we assume taxes will be deferred by doing a split rollover (earnings go to a traditional IRA), the advantage would be larger.”
Brian says
TFB, great analysis and spreadsheet, as always! Thanks.
Tip: add to your “Employer Match and/or Profit Sharing” (the red section) “Service-based Contributions”. These are pension contributions by employees and they count against the 53k max. I got burned by that last year, my pension contribution is 13k per year and therefore I over-contributed to my after-tax 401k.
Missing out on 13k of the benefit every year is irritating, but that quirk of pension tax law aside, the mega-backdoor is awesome!
Harry Sit says
Brian – Thank you. I replaced the legend with just “employer money.” That should cover everything the employer contributes.
Steve F says
Brian/Harry — Is it employee or employer pension contributions? (one of you said each one)
Brian says
Harry / Steve F
*employee* pension contributions (my HR refers to these as “service-based contributions”).
I do not know about employer pension contributions….my employer, unfortunately, does not contribute to my pension!
Harry Sit says
If the pension contributions are mandatory, it actually doesn’t matter that much whether they are employee contributions or employer contributions. Person A earning $113k with a mandatory $13k employee pension contributions and person B earning $100k with a $13k pension contribution from the employer both get $100k in cash and $13k contributed toward pension. The law sees the $13k as employer contribution.
Steve F says
Hmm. I guess I need to research that a little more. My employer makes a 7% “pension” (defined benefit) deposit. This doesn’t show up on my W-2 at all. This is in addition to the 5% match into the 401K (that does). I would have assumed the 5% counts and the 7% doesn’t towards the 53K limit. I’m interpreting Harry’s comment to say that they both count. I better get that straight before “maxing” out my after-tax contributions.
Harry Sit says
Steve – DB pension contribution doesn’t count. Brian’s must be a DC plan.
Brian says
Mine is a DB plan (it’s a traditional pension).
Pay stub labels the contribution literally “Defined Benefit Plan”.
Contribution is mandatory.
Does not show up on my W2.
It is after-tax (maybe that matters?)
I challenged HR on it, but they claim the 52k limit includes my DB pension contribution.
Harry Sit says
Brian – That’s weird, because the $52k/$53k limit comes from IRC section 415(c). The title of that section is “Limitation for defined contribution plans.”
http://www.law.cornell.edu/uscode/text/26/415#c
It doesn’t apply to contributions to a DB plan, no matter who make them. However, your employer is allowed to impose a lower limit than the law. If its plan is set up such that the limit is the 415(c) limit minus the mandatory DB contributions, it’s legal and there’s nothing you can do about it. If Steve’s employer just goes by the IRS limit, the 7% DB contributions don’t count.
Erik says
My plan says the following. Does that mean I could do this mega backdoor roth that I’m not sure I fully understand yet?
Rollover Contributions may be made after you commence employment. There are three types of rollovers:
Plan Rollover – If you have received a distribution from a retirement plan of a previous employer, you may generally roll the amounts over to the Plan within 60 days of the date you received the distribution. If the trustee of your prior plan withheld taxes on your distribution, you may be permitted to add other funds to the net payment you received so that 100% of your distribution is rolled into the Plan.
Direct Rollover – In most cases, amounts that you can receive from another tax-qualified plan may be directly rolled over to the Plan. Direct rollovers are not subject to withholding tax. You should ask the administrator of the other plan for instructions on making a direct rollover to the Plan.
IRA Rollover – Amounts held in an individual retirement account (“IRA”) that are from pre-tax contributions, including amounts that were received in a distribution from a tax-qualified plan of a previous employer, may be rolled into the Plan. Amounts from a Roth IRA may not be rolled into the Plan.
You may contact Vanguard for more information about Rollover Contributions.
Harry Sit says
No, that’s not the right place. If you look at the graph in the article, the money has to come from your paycheck, not from a previous plan or IRA. Look for it where you designate what % you want deducted from your paycheck. See if you have any option besides pre-tax and Roth.
Erik says
Okay, then I don’t. Just pre-tax and Roth options for me. Thanks!
George says
I am one of the fortunate ones in that my company allows after-tax contributions to our savings plan, in addition to allowing before tax and roth (also after-tax) contributions, within the prescribed limits.
Most people who retire from my company use the after-tax contributions they have made as part of their Net Unrealized Appreciation (NUA) strategy. This takes advantage of ones ability to receive a distribution of employer stock purchased in a qualified plan. Taxes (ordinary income taxes) have to be paid on only the cost of the employer stock; the appreciation is taxed as a long term capital gain when it is sold in the future, after being distributed. After-tax contribution can be credited against the cost of the stock, making it possible to remove a large amount from the 401k plan without any current tax obligations and only future long term capital gain tax obligations.
What I am wondering, and am beginning to model, is whether it is more attractive to use the after-tax balance in my 401k for a mega roth rollover, or to use it as part as an NUA strategy. Both are good uses, but I’m seeking the best.
Harry Sit says
Mega backdoor Roth is better. Once rolled over to Roth IRA, all future earnings are tax free. With NUA, the capital gains are still taxed. The lower capital gains tax rate is still not zero. You also have single-stock risk with NUA.
Bryan F. says
Harry- Regarding your comment: “The earnings on the after-tax contributions are still taxable when you roll the whole thing into a Roth IRA. If the earnings are substantial you can send the earnings to a traditional IRA.”
1. If my earnings are substantial in my company 401K, how do I go about sending the earnings to my traditional IRA. Does Fidelity separate out the non-Roth, after-tax contributions from the earnings for me??? Fidelity is our company’s 3rd or 4th custodian over my 13 years with the company. Also unfortunately I don’t think I would have kept my “after-tax” contribution records for the past 13 years.
2. On a separate note, if I were going to do:
a.) a regular “back door Roth” strategy with my traditional IRA….i.e. send all pre-tax money to my employer 401k/After-tax to my Roth…… AND ALSO
b.) do the Mega Backdoor Roth with in-service distribution (with contributions going to my Roth IRA and earning going to my traditional IRA).
Any recommendations on which process to do first?? Thanks!
Harry Sit says
1) You just ask them to send your rollover to two destination accounts: contributions to Roth IRA, earnings to traditional IRA. They know how much is after-tax contributions and how much is earnings.
2) Do the mega backdoor Roth first. The earnings will be sent back to the plan together with your other pre-tax money in the traditional IRA.
Dave says
Harry recommended doing step 2b (mega backdoor Roth) first so the after-tax earnings can be sent back to the 401k. Is that so the Traditional IRA can be left empty so it can be used for future nondeductible contributions followed by conversion to Roth IRA?
Harry Sit says
Dave – Yes.
Bryan F says
Thanks Harry.
I made my first moves for the Mega Backdoor Roth: I requested from my Fidelity Employer 401k account two rollover checks…one for the after-tax contributions that will go into my Roth IRA and the 2nd check for the earnings that will go into my traditional IRA.
I was reading up on my 2nd set of moves involving the “regular” backdoor Roth which 1.) I would wait until the checks cleared in my traditional and Roth IRA accounts 2.) I would then send almost all of my traditional IRA pre-tax money over to my employer 401k and then send the remainder (all past and current year after-tax contributions) to my Roth IRA.
My confusion comes in with your statement below:
No Rollover to Traditional IRA:
“When you are doing the backdoor Roth IRA, remember not to rollover from an employer-sponsored plan to a traditional IRA in the same year, either before or after you do the Roth conversion. You can rollover from one plan to another plan, or to your own solo 401k, just not to a traditional IRA.”
Can you help me through this or advise of what to do OR do I now have to wait until next year to do the regular backdoor Roth, because I broke the rule above.
Thanks.
Harry Sit says
For other readers, that came from Backdoor Roth: A Complete How-To. It was referring to simply repeating steps 2 to 5 every year after doing step 1 one time. If you do a rollover from a plan to a traditional IRA, you just have to do step 1 to clear the deck.
Bryan F says
Thanks Harry! Really appreciate it. Can you confirm that I am not missing anything (in this Mega back-door and regular backdoor Roth Combo) and also completing these steps in the right months 🙂
1. Complete rollover of my after-tax (EARNINGS) from my employer 401k to my Traditional IRA in Jan’15.
2. Complete rollover of my after-tax (CONTRIBUTIONS) from my employer 401k to my Roth IRA in Jan’15.
3. Complete rollover of all pre-tax funds (including the funds from step 1 above) from my Traditional IRA to my employer 401k in Feb ’15. Feels kind of strange that step 1. funds are going right back into 401k
4. Contribute $11K after-tax into my Traditional IRA in Mar. ’15 ($5500 for 2014 and $5500 for 2015).
5. Convert all remaining “after-tax” funds in my Traditional IRA to my Roth IRA in Mar ’15. This would include my Traditional IRA after-tax contributions from ’14 and ’15, as well as all other after-tax contributions from the last ’15 years.
6. Document in TurboTax (seems like this might be kind of complex with both the Mega and Regular backdoor)
Harry Sit says
Looks good. The only thing that has a hard deadline is the 2014 IRA contribution which must be done on or before April 15, 2015. Otherwise you are good as long as you complete everything in order in 2015.
Dave says
Are the following deviations from Bryan’s above six steps valid?
1) Executing step 3 immediately after steps 1 and 2. That is, rollover 401(k) after-tax contributions and earnings to Roth and Rollover IRAs, then send the Rollover IRA back to the 401(k) a day later. All rollovers in steps 1-3 would be direct rollovers.
2) Rollover (direct) multiple IRAs to 401(k) in step 3. After those rollovers, only nondeductible contributions (8606 basis), plus a small cushion, would exist across all Traditional IRAs.
Harry Sit says
Dave – Yes they are valid.