Breaking the Limits of Your 401(k) Plan
As we discussed in a previous post, your savings rate has a large impact on how soon you reach financial independence. If you’re looking to reach financial independence within 30 years, you need to save about 20% of your income. If you’re self-employed, the SEP IRA is a great vehicle for saving up to 25% of your income in a tax-sheltered retirement account. But if you’re an employee making more than $90,000 per year and have a 401(k) plan with a maximum contribution limit of $18,000, how do you save more than 20% of your income for retirement?
Let’s say you make $150,000 per year. The $18,000 maximum contribution allowed by a 401(k) plan is only going to get you to a savings rate of 12%. So how should you save $30,000, or 20% of your income, in the most tax-efficient manner for your financial independence?
The tax advantages of most retirement accounts like a 401(k) plan, IRA, and Roth IRA are that you get tax savings now or in the future. You either get a current tax deduction for your contributions or you enjoy tax-free withdrawals of your earnings in the future. Here’s a chart of these retirement account options and the tax advantages of each. Note that there are also contribution limits and limits based on your income (Federal Adjusted Gross Income).
Retirement Account Limits and Taxation
Amounts are effective for the 2015 tax year for taxpayers under age 50.
If you’re single and make $150,000 per year, you’re going to be limited to the amount you can contribute as a deductible Traditional IRA contribution or a Roth contribution. You could make a non-deductible contribution to your IRA, but you don’t get the current year tax deduction for it, and the earnings will be taxed when you withdraw them. You could convert that non-deductible contribution to a Roth IRA, also known as a backdoor Roth contribution. That helps you get tax-free earnings going forward, but if you have a traditional IRA account, you can’t use this method. You’re still limited to contributing $5,500 per year to the IRA or an additional 3.6% savings rate (on that $150,000 of income). So even if you are able to make the backdoor Roth contribution, you’re only at 15.6% savings. You may think the only thing left to do is to save the additional 4.4% in a taxable account and get no tax advantage. But there may be another way to legally break some limits and get this additional savings in a tax-advantaged retirement account.
Did you know about after-tax 401(k) contributions?
The total contributions that can be made to a 401(k) account are actually $53,000 or 100% of your salary. The $18,000 limit applies to pre-tax and Roth contributions. But you may have the ability to make after-tax contributions to the account if your plan allows it. The benefit of making additional after-tax contributions to your 401(k) is that you can use this method to eventually roll the money over to a Roth IRA, and from that point all earnings grow tax-free and withdrawals after 59 1/2 will be tax-free as well. You can do this even if your IRA contributions are limited due to your income, and the only limit is the $53,000 of total contributions to the 401(k) account. This is our chart with the after-tax 401(k) options.
Retirement Account Limits and Taxation
Amounts are effective for the 2015 tax year for taxpayers under age 50.
How to do it
First, make maximum contributions to your 401(k) plan as either pre-tax or Roth. You’ll be contributing $18,000, and if you’re in the 25% tax bracket, you’ll save $4,500 in Federal income taxes on your pre-tax contributions.
At the same time, you can contribute additional after-tax money to your 401(k) plan, if your plan allows it. The total contributions to your 401(k) plan, including your pre-tax, Roth, and after-tax contributions plus your employer’s contributions (e.g. the company match or profit sharing) cannot exceed $53,000 or 100% of your salary. Be careful not to contribute more than that. If you were able to make a backdoor Roth contribution of $5,500, you still need to save $6,500 more to get to the 20% saving rate. So you would make an after-tax contribution of $6,500 to your 401(k).
Normally, when you retire and start withdrawing funds from your 401(k), the original $6,500 you contributed after tax is free of income taxes. All earnings on that money, however, are taxed as ordinary income. Of course the $18,000 of pre-tax contributions and the earnings on that money are taxed as ordinary income as well. But, if you are able to rollover your 401(k) to an IRA account before you start withdrawing funds for retirement, you have the opportunity to save some of these taxes. In our example, you would rollover the $6,500 after-tax contribution (the original contribution amount only, and not the earnings) to the Roth IRA and rollover the pre-tax money and all earnings in the account to an IRA. You will pay no income taxes at the time of the rollover. The benefit of doing this is that going forward all earnings on your $6,500 of Roth assets grow tax-free!
By using this strategy, you are effectively accumulating money in your 401(k) with a much higher annual contribution limit to eventually roll it over to a Roth IRA. The sooner you can get the money out of your 401(k) and into the Roth, the better. It has that much longer to grow tax-free. One caveat though is you do need to rollover the entire balance of your 401(k) at the same time. The pre-tax portion and earnings need to be rolled over to a traditional IRA. The after-tax contributions need to be rolled over to a Roth IRA.
So you CAN break the limits of your 401(k) and save 20% (or more) of your income in tax-advantaged retirement accounts, even if you’re an employee with a high income.
Your Action Plan:
Contact your 401(k) Plan Administrator and find out if your 401(k) plan allows for after-tax 401(k) contributions above and beyond the $18,000 limit. After that, double check your financial plan. It should specifically spell out the dollar amount and type of account your savings will be directed to. If you don’t have a financial plan, it’s time you create one.