Whether you’re contributing to an IRA, 401(K), or a similar strategy, you will (likely) eventually hit a cap. The IRS limits total contributions depending on the retirement strategy you’re using, which works out to $19,500 (+6,500 for 50+) for a 401(K) and $6,000 ($7,500 for 50+ for most. If you earn between $140,000 and $198,000 (single/joint filing) that rate will be even lower, although you’ll have to calculate it based on your income and specific conditions. Once you’ve maxed out that contribution, what now? You still want to save for your retirement. If you have extra cashflow, tucking funds into your nest egg is a great way to ensure your future now – while reducing your tax bill as you age. But, how?
Depending on your employer, you may be able to contribute as much as twice the $19,500 maximum to your 401(K). While you may need some assistance from a tax advisor, like the retirement specialists at Tangent Retirement, the following strategies can help you enhance your retirement savings.
What Are After-Tax 401(K) Contributions?
The maximum contribution to a 401(K) or Roth 401(K) in 2021 is $19,500 with an optional $6,500 catch-up contribution if you’re over 50.
You’re also entitled to an additional employer contribution. Total contributions (yours + your employers) max out at a total of $58,000 or $64,500 including the catch-up contribution.
Most employers cash in on this by using 401(K) contributions as incentives and as part of pay in a format that is tax-reduced and convenient for both parties. Yet, most won’t even come close to maxing out the $58,000. That’s where after-tax contributions come in.
After-Tax contributions are an optional 401(K) contribution type. Some employers offer them, others don’t. It’s important to check if your employer actually enables them before proceeding. If not, consider discussing options with HR.
If your employer does offer after-tax contributions, you can simply contribute up to the maximum limit of your after-tax (you’ve paid income tax on this) dollars. You can then leave it in your 401(K) or consider the Mega Backdoor Roth 401(K). Most importantly, you can make after-tax 401(K) contributions after maxing out your 401(K) contributions or throughout the year. There’s no limit.
What does that look like?
Sandra makes $168,000 with her employer. She’s 52 and has the cash flow to contribute more to her retirement savings. Her employer offers a matching program of 100% for the first 4% of employees pay and 50% for the following 4% of pay.
Sandra contributes $19,500 + $6,500, reaching her $26,000 cap, or 11.6% of her total income. This falls under the normal 401(K) deductions.
Her employer matches this with $10,800. Sandra’s total contribution at this point is $36,800. This leaves up to $27,700 of contributions under the employer cap. Sandra’s employer offers after-tax 401(K) contributions, so Sandra can easily contribute more income if she wants.
Mega Backdoor Roth 401(K)
The Mega Backdoor Roth 401(K) uses the standard Roth 401(K) conversion with the above strategy. Rather than keeping the money in your employer’s 401(K) plan, you do an in plan Roth conversion. This allows your funds to grow tax-free for the duration of employment, but it will mean paying some taxes now. This can be hugely advantageous if you expect income to remain high after retirement. However, it can result in tax complications, such as paying double taxes, so it’s critical to see a tax specialist before attempting this strategy. However, if your employer does not allow you to move funds out of their retirement account, this strategy may not work for you.
Traditional 401(K)
- Contributions are not taxed
- Contributions and Gains are taxed as ordinary income upon normal (age 59.5) distribution
Roth 401(K)
- Contributions are taxed
- Contributions and gains are not taxed upon normal (age 59.5) distribution
Essentially, both offer advantages, but which is most advantageous to you depends on your current situation. Anyone attempting to convert after-tax 401(K) contributions into a Roth 401(K) should also be careful of triggering double tax obligations. Why? When you convert from a 401(K) to a Roth 401(K), you’ll pay tax on anything you haven’t already paid tax on. This means you’ll likely pay a percentage of tax on every transfer if you’re also making deductible contributions to the account (which you are).
What About IRA?
IRAs often make up a significant aspect of retirement accounts. Yet, if your income is too high, you’re virtually locked out of the Roth IRA. In fact, deductible contributions stop when your income hits $139,000 as a single filer. If you’re earning over $124,000 as a single filer, you’ll have to calculate total deductibles based on your Modified Adjusted Gross Income.
The Non-Deductible IRA allows you to make the maximum IRA contribution, but after tax. This means you can contribute $6,000 or $7,500 with the catch-up contribution, after paying income tax on the amount.
Backdoor Roth IRA
While you can’t contribute to a Roth IRA with a higher income, you can easily convert money from a after-tax traditional IRA to a Roth IRA. Here, it’s always important to assess the state of your existing IRA. Most could benefit from a financial analysis and expert advice before doing so. For example, it may be essential to open a new IRA before leveraging Non-Deductible Contributions. Why? When you convert money from an IRA to a Roth IRA, you’ll pay tax on any contributions that haven’t already been taxed. However, moving funds to a Roth IRA can be advantageous, simply because you won’t pay tax on gains throughout the lifetime of the account.
If you think you’ve maxed out your retirement contributions, chances are, you can still contribute more. However, your ability to do so depends on your employer, their policies, and your income. If you own your own business, you can likely easily set up the right accounts for your own use. However, it’s important not to proceed without tax advice and a tax strategy to ensure that you don’t end up facing hefty tax bills on your retirement savings.
If you have any questions about your retirement contributions Tangent Retirement can help. Our advisors specialize in retirement planning and we can help you navigate the complex decisions involved to ensure your planning and retirement savings are managed to your best advantage. Contact us today.
This information is for reference only and should be reviewed with a qualified professional as you situation may vary from others. Nothing mentioned above is a guarantee nor should this be considered advice.
Golden State does not and cannot deliver tax advice and the material herein is for information only. Please consult a qualified tax professional for opinions related to your particular situation.
Investment advisory services are offered through Golden State Equity Partners, LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Tangent Retirement is a DBA of Golden State Equity Partners, LLC.
