When it comes to retirement planning, the universal advice you’ll encounter is to max out your 401(k), especially if your company offers a contribution match.
But what if you’ve already met your annual contribution limit? Are there other ways you can save for retirement?
Today we’ll explore unique savings opportunities to truly “max” out your retirement savings vehicles.
Key Takeaways:
- After-tax contributions are a way for you to hit the total 401(k) limit.
- Mega backdoor Roths allow you to save an extra $45,000, but it’s complicated.
- There are other savings options outside your retirement account, like taxable accounts and an HSA.
Before we jump into our savings tips, let’s revisit the 401(k) contribution limits. Remember three numbers:
- Your annual contribution limit
- The cumulative limit for you and your employer
- The catch-up limit for employees 50 and older
Say you’re at least 50 and elect to defer the entire allowable $27,000 to your 401(k) in 2022. After factoring in the company match, your total annual contribution comes to $37,000.
According to the IRS, you can’t contribute more pre-tax dollars to your 401(k), but you still have $30,500 before you hit the limit. So, what can you do?
Savings Tip #1: After-Tax Contributions
After-tax contributions are any contributions you make to your 401(k) with after-tax dollars. So, unlike your pre-tax payroll deferrals, you will pay taxes on the money before it hits your account.
Many people consider this strategy after maxing out their annual pre-tax employee contribution, though your plan may allow you to make them before reaching that threshold.
Your after-tax contributions can still pull directly from your paycheck and will grow with the rest of your retirement funds. Since you’ve already paid taxes on the way in, this money is portable, and you may withdraw after-tax contributions (not earnings) at any time without tax or penalty.
But there are a few prohibitions to keep in mind.
- Your employer must allow after-tax contributions to their 401(k) plan. Many do, but you’ll want to check beforehand.
- Earnings grow-tax deferred until withdrawn, and there may be a 10% penalty if you withdraw before 59½.
One option to leverage after-tax contributions is converting them to Roth accounts, whether a 401(k) or IRA. When you do this, you change the tax characteristics of the money and could be eligible for tax-free growth and distributions provided you meet the IRS requirements.
After-tax contributions can be an excellent opportunity to stash away more money for retirement and truly “maximize” your workplace tax-advantaged account. Plus, this strategy opens up unique opportunities like Roth conversions and rollovers, further boosting your after-tax bucket.
What’s The Difference Between After-Tax Contributions and a Roth 401(k)?
It’s easy to confuse after-tax contributions with Roth 401(k) deferrals since you contribute to both with after-tax dollars, and neither option lowers your taxable income in the year you contribute.
But there are distinct differences to remember.
First, Roth 401(k)s are subject to the IRS annual contribution limit of $20,500 in 2022, and after-tax contributions aren’t. Why not?
Since the IRS doesn’t consider after-tax contributions “deferrals,” they don’t have to follow the same rules. Instead of being beholden to the annual contribution limit, after-tax contributions must remain within the larger total contribution limit.
But even though you have more flexibility in how much you can contribute, you’ll still need to pay income tax on any earnings from after-tax contributions, which you wouldn’t with a Roth 401(k), leading us to tip #2.
Savings Tip #2: Convert Contributions To A Roth Account
You may be able to keep your after-tax contribution withdrawals (contributions and earnings) tax-free by converting them into a Roth account.
There are a couple of approaches to consider:
- In-plan conversion. Some plans allow you to convert your after-tax contributions into a Roth account within the same plan, like a Roth 401(k). You may also be able to enroll in auto-conversion features to streamline the process. If you go this route, consult your financial and tax professionals, as you may need to pay taxes on any earnings from your contributions once you convert.
- In-service withdrawal/distribution. You might be able to take a withdrawal from your account while still working at your company. This strategy allows for a mega backdoor Roth IRA or converting your after-tax contributions into a separate Roth IRA.
Mega backdoor Roth IRAs tend to get a lot of attention, but they are quite complex, so let’s explore them a little deeper.
What Makes This Conversion so “Mega”?
Typical backdoor Roth IRA conversions are advantageous for someone who doesn’t qualify to contribute directly to a Roth IRA account and would like to build up a tax-free account.
In this scenario, you would open a traditional IRA, contribute up to $6,000 (or $7,000 if you’re over 50), then convert those funds into a Roth IRA.
You can also roll over money from a traditional 401(k) to a traditional IRA and then make the conversion, but you’ll have to pay taxes on any pre-tax dollars you convert.
A mega backdoor conversion lets you roll over all of your after-tax contributions to a Roth IRA. If you’re under 50 and don’t have an employer offering a matching contribution, you could roll over as much as $40,500.
Mega Backdoor Stipulations
There are some criteria you and your 401(k) account have to meet to make this work.
- Your 401(k) plan must allow after-tax conversions. If your plan doesn’t, you can still look at a regular backdoor conversion through a traditional IRA account.
- Your 401(k) plan must allow in-plan distribution, where you can transfer 401(k) funds to an outside IRA while still employed. A mega backdoor depends on after-tax contributions being withdrawn almost as soon as their deposited to avoid paying additional taxes on any gains during the rollover event.
People who often benefit the most from this type of conversion are:
- High earners who don’t qualify to directly contribute to Roth IRAs and have maxed out their 401(k) and traditional IRA contributions.
- Those who want to take advantage of tax-free growth—timing is crucial.
- Those who don’t need the funds within five years of the conversion.
If this describes your earnings situation, a mega backdoor might help you build up your tax-free retirement account.
Mega backdoor Roth IRAs can be advantageous, but there’s also much to consider. Talk to your financial and tax advisor before initiating.
Savings Tip #3: Boost Contributions to a Taxable Account
Ready for a simpler tip? Look outside of retirement accounts!
If you have some cash to spare, you can put it to work in a taxable brokerage account. Unlike 401(k)s, you have a broader range of investment selections and can implement more tailored strategies.
Plus, taxable brokerage accounts come with their own unique tax benefits. While not technically tax-advantaged, income (gains, dividends, interest, etc.) may be subject to the more favorable long-term capital gains tax rate should you hold the security for at least a year.
Free of the withdrawal restraints of a retirement account, you can use your gains from this account to pay off your mortgage, go on an extra vacation, cover your child’s tuition, or set up 529 education plans for your grandchildren.
Savings Tip #4: Don’t Forget About Your HSA
A health savings account (HSA) is a valuable long-term planning tool. Since healthcare costs are projected to continue rising, you’ll want to ensure you have the money to cover your healthcare costs if Medicare isn’t enough.
To qualify to contribute to an HSA, you or your spouse must be enrolled in a high-deductible health plan (HDHP). Every contribution, gain, and distribution made towards a qualified medical expense is tax-free.
If possible, redirect resources to max out your account.
There you have it, four planning tips to consider once you’ve maxed out your 401(k). Some are admittedly more complicated than others.
Before you decide what to do with any extra cash, it’s important to review some of your other financial goals before building up retirement accounts.
Whatever your personal goals are, Metanoia is here to help. Schedule a free consultation to learn more about maximizing your savings opportunities.
