Not every employer sponsored 401(k) plan is created equal. Many larger employers plans allow “After-Tax Contributions”, inside their 401(k) plan. These “After-Tax Contributions” often are for contributions made by an employee above the employee contribution limit, but some plans allow you to contribute to them over time. Employees with plans allowing these types of contributions can contribute more than the $23,000 employee limit ($30,500 including catch up over age 50) in a tax advantaged way. These employees are still limited to the 415(c) limit of $69,000, which is the total contribution limit to defined contribution plans by both the employee and employer.
After-Tax contributions to these plans are often confused with Roth 401(k) contributions. There is an important distinction between the accounts and how earnings are taxed. Roth 401(k) contributions are made after-tax, and earnings grow tax free. After-tax contributions are made after-tax, but earnings grow tax deferred instead of tax free. For future distributions, it is important to follow the guidelines on qualified withdrawals from tax-advantaged accounts to achieve favorable tax treatment and avoid penalties.
Despite the less favorable tax treatment of earnings on after-tax contributions, the employee can typically still contribute more than the $23,000 ($30,500 including catch up) employee limit to a tax advantaged account. What if they could take advantage of both higher contributions to tax advantaged accounts, and the more favorable tax-free growth on earnings? Thankfully there is often a way to do just that. Cue in the “Mega Backdoor Roth” strategy.
Many employer sponsored plans allow the employee to roll the contributions made on an after-tax basis to a Roth IRA. Once those contributions are moved into a Roth IRA, the earnings can grow completely tax free for future qualified withdrawals. In contrast, if the employee leaves contributions in the employer sponsored “after-tax” bucket, the earnings will be taxable upon withdrawal. If after-tax contributions have been held in the employer sponsored plan for a while, there is a decent chance there have been tax-deferred earnings on the balance. How those earnings are managed in the “Mega Backdoor Roth” transaction depends on the individual’s unique circumstances and can influence other strategies in a comprehensive plan.
Optimizing your employer sponsored plan is a key ingredient to building wealth and achieving your goals. There are important considerations when executing strategies like these. Our team has the experts to help you implement your plan and avoid surprises. Schedule a 15-minute introductory call to learn how we can help: click here.
Connor Michael, CFP®
Financial Advisor
Alaska Wealth Advisors, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Alaska Wealth Advisors’ investment advisory services can be found in its Form ADV Part 2 and/or Form CRS, both of which are available upon request. Material presented has been derived from sources considered to be reliable, but accuracy and completeness cannot be guaranteed.
Note: This material should not be construed as tax advice. You should always consult with your tax professional with regard to specific tax questions and obligations.
CFP – Certified Financial PlannersTM (CFP®) are licensed by the CFP® Board to use the CFP® mark. CFP® certification requirements include: Bachelor’s degree from an accredited college or university, completion of the financial planning education requirements set by the CFP® Board (www.cfp.net), successful completion of the CFP® Certification Exam, comprised of two three-hour sessions, experience requirement: 6,000 hours of professional experience related to the financial planning process, or 4,000 hours of Apprenticeship experience that meets additional requirements, successfully pass the Candidate Fitness Standards and background check, agree annually to be bound by CFP® Board’s Standards of Professional Conduct, and complete 30 hours of continuing education every two years, including two hours on the Code of Ethics and Standards of Professional Conduct.
