Removing the Roth IRA Contribution Limit With 401(k) Dollars

Generating after-tax income can be critical in developing a well-balanced retirement income plan—but for clients who have delayed saving or wish to accumulate a substantial Roth nest egg, the annual contribution limits for retirement savings can present a formidable roadblock.

Fortunately, back-door routes to funding a Roth IRA have developed to allow clients to grow these accounts much more quickly. One of these routes cuts right through one of the most commonly available retirement planning tools—the traditional, employer-sponsored 401(k)—but it’s important that the client be apprised of several important consequences of this particular savings technique before taking any action.

Many clients are unaware that 401(k) contribution options spread much further than the ability to defer the traditional annual pre-tax contribution limit ($18,000 in 2015, or $24,000 for clients age 50 and over). While deferring wages up to this contribution limit is the goal for some clients, in order to truly maximize the 401(k) option, others have sought to take advantage of the after-tax contribution limit as a means to eventually fund a Roth IRA.  This after-tax limit allows the client to defer more than the annual pre-tax limit to his or her 401(k), for a total of up to $53,000 or 100% of compensation in 2015.

Luckily for taxpayers, the IRS now makes it easier to use 401(k) dollars to fund a Roth by allowing a 401(k) distribution to be treated as a single distribution even if it contains both pre-tax and after-tax contributions. This is the case even if those contributions are rolled over into separate accounts, as long as the amounts are scheduled to be distributed at the same time.

For higher-income clients who are able to contribute more than the maximum pre-tax contribution, contributing additional after-tax dollars can allow them to “overfund” a Roth account at a later time.  If the 401(k) allows for after-tax contributions, these clients can contribute after-tax dollars and later separate those funds from pre-tax contributions and roll them over into a Roth upon exiting the employer-sponsored plan, without tax liability.

In order to roll the entire after-tax 401(k) balance into a Roth IRA, however, the client must move the entire 401(k) balance into a new account.

Practical Concerns

Clients should note that making an after-tax contribution to a traditional 401(k) is different than contributing to a Roth 401(k), where contributions are limited to the pre-tax maximum that applies to traditional accounts even though they are made on an after-tax basis. Further, earnings on contributions to a Roth 401(k) grow tax-free, while earnings on after-tax contributions to a traditional account are only tax-deferred (even though the contribution itself will not be taxed again upon withdrawal).

Earnings on these after-tax contributions do not begin to generate tax-free growth until they are rolled over into a Roth IRA. However, indirectly funding a Roth IRA through a 401(k) will eventually allow a client to accumulate a larger Roth balance than would otherwise be possible, given the relatively low $5,500 per year (in 2015) IRA contribution limits.

While this backdoor route to funding a Roth IRA with 401(k) funds may be attractive to higher income clients who have exhausted other contribution options, unfortunately not all employer-sponsored plans give clients the option of contributing after-tax dollars.  Regardless of the IRS’ position on the treatment of after-tax contributions, the terms of the individual plan control whether the client will be able to take advantage of the strategy by contributing after-tax dollars in excess of the pre-tax limit.


Conclusion

For many plans, offering the after-tax contribution option simply presents an administrative burden that the plan sponsor is unwilling to assume.

The IRS’ willingness to allow separation of pre-and after-tax contributions for rollover purposes, however, has made this Roth funding strategy more attractive to many taxpayers—which could result in more plans offering the after-tax contribution option in the future.

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