Do you max out your 401k every year? What if I told you there is an almost 50% chance that you might be missing the opportunity to put another $30k or more into a Roth IRA through your 401k each year? I’ll put it another way:
- 48% of retirement plans allow employees to make after-tax contributions to their 401k.
- In Notice 2014-54, the IRS gave permission to plan participants to convert after-tax contributions to a Roth IRA beginning in 2015.
- Of the 401k plans that have a Roth component, 33% allow for in-plan Roth conversions.
So what does this mean to you? First, let’s compare the ways money can go into your 401k:
Your contribution (updated for 2019 limitations):
|Employee contributions||Employer contributions||How taxed|
|Pre-tax||Lesser of $19,000 or wages||Optional matching||100% at withdrawal|
|Roth||Lesser of $19,000 or wages||Optional matching||0% at withdrawal|
|Non-Roth After-tax (NRATs)||$56k ($62k if age 50+) less total contributed by employee and employer||N/A||Contributions not taxed but growth is taxed at conversion or withdrawal|
Some employers add a profit-sharing component: With profit-sharing added to your 401k, your employer may contribute up to an additional 25% of your compensation.
Now, let’s look at what this means to you in real life:
48% of 401k plans allow employees to make Non-Roth After-Tax (NRAT) contributions to their 401k accounts. Because these contributions were fully taxed at the time they were made and employees had to pay taxes at their top marginal tax rates on any growth in the NRATs, they were largely ignored, and rightfully so. It was much more beneficial to put money in a “taxable” account and pay taxes on the growth and dividends at a top rate of 20% (15% before 2014).
That was then, this is now:
In late 2014, the IRS notified us that they would allow these NRAT contributions to be converted to Roth IRAs beginning in 2015. This was HUGE, but most employees have overlooked the implications. Why? Because they just remember the old, onerous rules under which we were limited to a small annual Roth (or back-door Roth) contribution of $5,500 per person. Of course, you could still convert a pre-tax account to a Roth – and pay top marginal tax rates on the growth.
So what are the implications? If your plan is one of the almost 50% of plans allowing NRATs, and you are looking for a way to get $56k into your 401k, the IRS just dropped a gift in your lap. How? Let’s look at an example:
Dr. Joe earns $250k working for a hospital with a 401k that matches 100% of the first 4% he adds to the plan. Dr. Joe contributes the full $19k he is allowed to put in and the employer contributes $10k for a total of $29k. If the hospital allows NRATs, Dr. Joe can put in an additional $27k to get a full $56k into his account.
If Dr. Joe contributes $25k to his NRAT per year and leaves after 5 years, he will have $125k, plus whatever growth has built up, in the NRAT part of his 401k. At that time, he is allowed to roll the whole amount of his NRAT to a Roth IRA! He will taxes only on the growth. That means he will get to roll at least $125k into a Roth IRA – and he doesn’t have to do it through the “back door” even though he earns too much to contribute to a personal Roth!
It gets better:
Many employers allow in-service rollovers. If Joe’s employer is one, Joe can immediately roll his NRAT contributions to a Roth IRA and let the tax-free growth begin immediately!
NRATs are a tremendous opportunity for doctors and other high-income professionals who have been frustrated by the inability to get a full $56k into their 401k’s each year. Remember: you can contribute beyond the previous $19k contribution limitation and fill up your 401k as long as your plan allows NRAT contributions. Check with your HR department – and if you don’t have that option, start lobbying for it!*
We’ve talked a lot about Roth IRAs – what exactly is a Roth IRA and why is it important for you to have one? Michelle explains about Roth IRAs in her vlog.
 subject to some exceptions.
*Note that if your employer has non-HCE employees who do not participate, the plan may not pass discrimination testing.