Author Topic: Is anyone contributing to an after tax 401k?  (Read 2972 times)

MayDay

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Is anyone contributing to an after tax 401k?
« on: September 17, 2015, 08:46:32 AM »
This is an option at H's work.  We will likely accidentally do it this year as H's bonus gets put into the 401K at the usual percentage, making exact calculations impossible.  So we started doing rsome reading on whether we should try to overshoot or undershoot the annual contribution limit. 

Everything I google is confusing, made more so by the fact that info about Roth 401k's is often mixed interchangably with after tax 401k's. 

From what I can tell, though, whatever we put in the after tax 401k, we can put the contributions directly into a Roth IRA if/when he leaves the company, and any interest earnings can be rolled into the regular IRA with the rest of the 401k balance. 

That seems fairly straightforward, but I am wondering how much of an accounting nightmare if will be to separate the money out.  The account is with Fidelity if that matters.

One possibility is to try to throw a ton of money in the after tax 401k as he plans to leave this employer in the next year or so.  So we could effectively dump a ton of money in his Roth IRA pretty quickly.  But that would mean less in our taxable brokerage account (intended for medium term purchases like house DP, replacement car, and then eventually ER). 

If you have this option, talk me through your choices.  If you have a brilliant understanding of this option, can you correct any misconceptions that I have?

ZiziPB

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Re: Is anyone contributing to an after tax 401k?
« Reply #1 on: September 17, 2015, 09:04:57 AM »
Hi MayDay, I contribute to after tax 401k.  I generally aim to reach the overall IRS contribution limit between my pre-tax contributions, the match and the after tax contributions ($53,000 per year, I believe - will not reach it this year).  I think it makes sense to contribute after tax if you would have saved the money for retirement anyway.  If you have other saving priorities, I don't think it makes sense to do this.

People call this a Mega Backdoor Roth.  The idea is that you will eventually either rollover the money to a Roth IRA or convert it to Roth within the plan.  So the plan should allow either in-service distributions or conversions (or you are planning to leave your employer in the near future).  Generally, you don't want the after tax money accrue a lot of interest before you convert it to Roth because any earnings/interest on it is taxable.  Although, recent guidance from IRS allows split rollovers where the contributions would go into a Roth IRA and the earnings would go into a tIRA, so you can avoid a taxable event at rollover/conversion.  But the sooner you can convert it to Roth, the better, so that the money can grow tax-free.

Trudie

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Re: Is anyone contributing to an after tax 401k?
« Reply #2 on: September 17, 2015, 09:09:25 AM »
Hi MayDay, I contribute to after tax 401k.  I generally aim to reach the overall IRS contribution limit between my pre-tax contributions, the match and the after tax contributions ($53,000 per year, I believe - will not reach it this year).  I think it makes sense to contribute after tax if you would have saved the money for retirement anyway.  If you have other saving priorities, I don't think it makes sense to do this.

People call this a Mega Backdoor Roth.  The idea is that you will eventually either rollover the money to a Roth IRA or convert it to Roth within the plan.  So the plan should allow either in-service distributions or conversions (or you are planning to leave your employer in the near future).  Generally, you don't want the after tax money accrue a lot of interest before you convert it to Roth because any earnings/interest on it is taxable.  Although, recent guidance from IRS allows split rollovers where the contributions would go into a Roth IRA and the earnings would go into a tIRA, so you can avoid a taxable event at rollover/conversion.  But the sooner you can convert it to Roth, the better, so that the money can grow tax-free.

This is a really good summary of the process.  I just gained this option through my 401K (switched administrators) and am going to start this process in 2016.  However, I will be maxing out my pre-tax contributions and my Roth IRA contributions first.

MayDay

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Re: Is anyone contributing to an after tax 401k?
« Reply #3 on: September 17, 2015, 09:14:21 AM »
Zizi, that aligns with my understanding, so your post makes me happy.

But I totally didn't realize it was the same as the mega backdoor Roth!  That should make googling much easier.  I thought the mega backdoor Roth was something else.

Understanding check on Roth's:  you can take out your contributions anytime, right?  So besides being tax-free, it lets you use them for ER?  But then I guess if you use too much in a year, you have no taxable income and it might put you on Medicaid? 

Navigating all of this makes my blood boil.  Our retirement system is horrible.  Its so unfair that some people get offered these magical tax-savings vehicles and others get nothing except the piddle 5K a year IRA contributions.  H and I are smart and mathy and we still get seriously confused. 

Spork

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Re: Is anyone contributing to an after tax 401k?
« Reply #4 on: September 17, 2015, 09:18:03 AM »
I did about 5 years of Roth 401k after tax.  I knew I was FIRE'ing at the end of it and thought it would be better to pay the taxes up front than to try to ladder it through a Roth later.

I can assure you the end rollover (a mix of traditional 401k and roth 401k) was easy and straight forward.  I just called Vanguard and gave them the account information.  They bridged in the 401k provider as a 3 way call.  They spoke "the right language" to each other for about 10 minutes, provider mailed a check directly to Vanguard and it all went in the right places.  Easy.

seattlecyclone

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Re: Is anyone contributing to an after tax 401k?
« Reply #5 on: September 17, 2015, 09:41:14 AM »
I do the mega backdoor Roth and it's great! I get to contribute so much more to my Roth account because of this that would otherwise need to go into a taxable brokerage account.

Understanding check on Roth's:  you can take out your contributions anytime, right?  So besides being tax-free, it lets you use them for ER?  But then I guess if you use too much in a year, you have no taxable income and it might put you on Medicaid?

You can take out your whole Roth IRA balance at any time. Nobody is stopping you. Once you have taken out more than your total contributions and conversions, you would have to pay your marginal income tax rate plus 10% on any excess if you aren't 59 yet, so this generally isn't a good idea. The contributions and conversions always come out tax-free. Contributions never have a 10% early withdrawal penalty, conversions only have this if you withdraw them within five years and you paid tax on the amount at the time of conversion.

You're right that any tax-free Roth withdrawals don't count as income for the purpose of calculating your MAGI for ACA health insurance subsidies. However if you still have some pre-tax retirement funds you can convert exactly as much to Roth as you need to hit your target income for the best subsidies. Then five years down the line you can withdraw that money to use for your living expenses, convert just enough money to Roth to get the best health insurance subsidies; wash, rinse, repeat.

JustGettingStarted1980

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Re: Is anyone contributing to an after tax 401k?
« Reply #6 on: September 17, 2015, 10:44:45 AM »
Hello, and great question!

My company also has an After-Tax 401K contribution possibility, but I called the administrator, and they do not allow in-service distributions or conversions.

The way I see it. When I begin to contribute past the $18000 limit, I will basically consider it a Taxable Account that I can convert to a Roth IRA eventually.

Say I do this for the 5 years prior to RE, I can have approx $21000 x 5 = $105000 extra in my Roth IRA. Am I understanding this correctly?  When I leave my job, I'll do the "Mega Backdoor Roth" and convert/transfer the After Tax 401K to my Roth IRA (but I cannot do that till I leave my job).

Does this also mean I cannot withdrawal earnings for 5 years on that 105K without the 10% penalty? (but I can withdraw contributions with no penalty?)

Thanks for the helpful input, folks!
« Last Edit: September 17, 2015, 10:46:37 AM by JustGettingStarted1980 »

seattlecyclone

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Re: Is anyone contributing to an after tax 401k?
« Reply #7 on: September 17, 2015, 11:44:02 AM »
Does this also mean I cannot withdrawal earnings for 5 years on that 105K without the 10% penalty? (but I can withdraw contributions with no penalty?)

This is a little bit complicated. The way the Roth IRA ordering rules work, any direct contributions to the Roth IRA come out first ("backdoor" and "mega backdoor" contributions don't count here). Then once you have withdrawn all of your contributions, traditional-to-Roth conversions come out, oldest first. Your "backdoor contributions" count as conversions for this purpose. If a particular conversion contained a mix of pre-tax and post-tax funds, the pre-tax funds come out first. These funds are subject to a 10% early withdrawal penalty if withdrawn within five years of the time you did the Roth conversion. The post-tax funds have no penalty upon withdrawal, no matter when you withdraw them.

Suppose you opened your first Roth IRA last year and contributed $5k. Then this year you converted $30k from your after-tax 401(k): $20k of contributions and $10k of earnings. You'll owe tax on the $10k of earnings this year. If you withdraw $25k from your Roth IRA next year, the first $5k out is the original contributions. No tax or penalty there. Then the conversions come out: originally taxable part first. So the next $10k would be subject to a 10% penalty because you paid tax on it when you converted it. After that, the final $10k would be tax-free and penalty-free because it was after-tax money to begin with.

Note that if you do the newly-allowed split rollover where you put the contributions in the Roth IRA and earnings in a traditional IRA, you don't have any conversions that are subject to tax. In the above scenario you would only have $25k in your Roth IRA instead of $35k, but you could withdraw the entire sum penalty-free.

Trudie

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Re: Is anyone contributing to an after tax 401k?
« Reply #8 on: September 17, 2015, 01:04:43 PM »
@Seattlecyclone - Doesn't the IRS consider all your Roth's as one when applying these rules?  I'm confused about the five year rule.

I ask because I will be 50 when I retire (5-6 years from now).  I'm trying to understand options for topping my Roth.  My last conversion was in 1999 or so.  I am hoping to start doing mega back door roth in 2016.

seattlecyclone

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Re: Is anyone contributing to an after tax 401k?
« Reply #9 on: September 17, 2015, 01:35:59 PM »
@Seattlecyclone - Doesn't the IRS consider all your Roth's as one when applying these rules?  I'm confused about the five year rule.

I ask because I will be 50 when I retire (5-6 years from now).  I'm trying to understand options for topping my Roth.  My last conversion was in 1999 or so.  I am hoping to start doing mega back door roth in 2016.

All of your Roth IRAs are considered to be one. All of your traditional IRAs are considered to be one. They are separate from each other. Any 401(k) accounts you have are separate from each other and from your IRAs. Does that answer your question?