If you’re earning a six-figure salary and enrolled in a company 401(k) plan, here’s a “hot investment tip” that could result in significant annual tax savings and a larger future nest egg—and you may not need to save a penny more than you’re saving now.
Warning, this article is going to get into the specific math and legal details of how to execute a tax strategy. If you want it explained in plain English, call your Abacus advisor.
What You’re Doing Now
You defer a portion of each paycheck to your 401(k) or Roth 401(k) and probably receive an employer match. Any additional savings are held in a personal or trust (i.e., non-retirement) account. The 401(k) money grows tax-deferred and your other money is taxed along the way. Thus, your tax-deferred money should grow at a faster pace.
The Missed Opportunity
In most cases, your deferrals and the matching contributions will not get you to the maximum employee/employer contribution allowed by the IRS. For example, let’s say you’re over 50, earn $200,000, defer the maximum of $24,000 and get a match totaling $8,000. That’s $32,000 in total contributions. But wait—the IRS allows you to contribute up to $53,000. So, how is it possible to get an additional $21,000 in your account?
The Roth 401(k) Loophole
Using the same example as above, if your 401(k) plan is set up to allow it, you can add $21,000 of after-tax dollars to your 401(k). If you do this for, say, 15 years, that’s $315,000 of contributions (your cost basis), plus whatever portfolio appreciation you get. You don’t get a current deduction, but the growth is still tax-deferred.
New IRS rules will allow you to withdraw funds from your 401(k) at one of two trigger events:
- You leave employment with the company.
- The plan allows you to take an “in-service distribution” [meaning that your 401(k) plan allows you to roll funds to an outside IRA or Roth IRA before you leave the company].
At either trigger event, you would cherry-pick the $315,000 and move just those funds to a Roth IRA. The remaining balance can be rolled to a traditional IRA. Voila!
If your personal spending doesn’t allow for deferring more of your take-home pay into your portfolio, you can still use this strategy but only if you have significant non-retirement account reserves. You just make withdrawals from those accounts to offset the additional saving you’re doing into your 401(k).
Ask your employer two questions and share your responses with your advisor:
- Are after-tax 401(k) contributions permitted?
- Are in-service distributions permitted?
There may be unique circumstances that limit how much you can add in total to your 401(k), so consult with your advisor and CPA before engaging in this strategy.