I am writing this specifically for Jonathan and Brad. This was one of the finest finds for me in the personal finance space and I want the community to take advantage of it ASAP. In my other posts Simplifying saving for college and How to get your money into Roth IRA even when IRS prohibits it? , I talk a lot about how to get more money into Roth IRA. This is especially very important for the people who have already maxed out all pretax contribution opportunities like pretax 401K, HSA etc. This is the last post in the series.
Who should do it?
Let’s say you have reasonable high income and you already do the following:
- $18,000 in pretax 401K.
- $5500 in Traditional IRA or Roth IRA or Backdoor Roth (see How to get your money into Roth IRA even when IRS prohibits it?)
- $3400 in HSA ($6750 for married filing jointly).
- Also maximize other pretax vehicles if at your disposal.
After doing all the above things, if you still have money leftover to invest, please don’t invest it in a taxable account. Instead, invest it in Roth IRA via the Mega Roth because Roth IRA has some major advantages. (see Simplifying saving for college).
How does it work?
A Traditional 401K has a contribution limit of $54,000 (first surprise! most people think it is $18,000). Here are the usual ways money goes into your 401K.
- Your pretax contribution- $18000 limit in 2017.
- Your employer’s matching- different companies have different rules.
- Your after-tax contribution (let’s call it ATC).
ATC is where the magic happens. In a hypothetical example for Mr. Kirti, here is the breakup.
- Mr. Kirti contributes $18,000 of his pretax income to 401K.
- His employer matches $9000. (again, goes into account as magic pretax money)
- Mr. Kirti makes another $27,000 ($54,000- $18,000- $9,000) of ATC.
What happens to the 27K worth of ATC?
- It can be left there till retirement. Not very advantageous because money does not grow tax-free (unlike Roth IRA).
- Can we rolled over into Roth IRA called the Mega Backdoor into Roth.
Can I do this as well just like Mr. Kirti?
- Not everyone’s employer’s 401K allows this. Your plan needs to allow something called In-Service distribution since you are still working at the company.
How often can I do this?
- Mr. Kirti’s 401K administrator allows him to take one In-service distribution every 12 months. But your plan might have different rules.
How should I go about doing this?
- Call your 401K provider and ask them about In-service distribution. If they allow it, go to the next step.
- Ask them the number of such distributions allowed and any costs associated with it. If any number of such distributions are allowed without any costs, take these distributions after every paycheck. You will most likely get a check for “<company which holds your Roth IRA> for the benefit of <your name>”.
- If they allow only one such distribution every 12 months, then try to make your after-tax contributions into the 401K in a shorter interval of time. Eg. make ATCs around bonus time or make the maximum allowed (% of your paycheck) ATC for some consecutive number of paychecks till you reach the max cap. The reason it is important to cluster it in such a way is because your contributions might grow if left in the 401K account for long and you have to understand what happens to the growth.
So, what happens to the growth?
- First, you decide if you want to have growth or not while your money is sitting in 401K, waiting to be rolled over to Roth IRA. You need to decide because the growth can lead to a taxable event (it matters when you are trying to keep your Modified Adjusted Gross Income-MAGI within a certain level). Mr. Kirti likes to let it grow since in his case, “growth minus taxes” is still superior than “no growth and no taxes” because he cannot possibly benefit very much by keeping his MAGI low by relinquishing real growth since he won’t be eligible for any benefits anytime soon.
- If you don’t want it to grow, just put it in a Settlement account (usually money market) in the 401K and when the roll over into Roth happens, there is no taxable event.
- If you invested it in the stock market, it might have grown. Now you decide how you want to handle the growth.
- Take it to Roth IRA: Taxable event- you pay the taxes on the growth portion that year.
- Move the growth/earnings portion into Traditional IRA: this makes sense for people who never intend to do the regular Backdoor Roth because if and when they do the regular Backdoor Roth, they will have a big taxable event. If you intend to separate out the In-service distribution between contributions and growth, make sure you know the respective amounts (your 401K provider tracks the cost basis of the ATCs).
That’s it. If you have any more questions, ping me via the blog or pester Brad and Jonathan. Let me know how it goes for you and feel free to provide constructive feedback. Happy investing!