Save on tax: After Tax 401K with Roth IRA Conversion

My company has recently started to offer after tax 401k option.  As I have been looking for all ways to reduce taxes, I did quite a bit of research on this topic and want to share my findings.   Let me start with the bottom line first, “For high income individual/families, this is an awesome to increase your contribution in Roth IRA.”  I won’t cover the virtues of Roth IRA here, there are ample materials on this topic already.  

What’s after tax 401k and how does it work?

On a pretax basis, employees can contribute up to $18,000 (2015 limit) per year to their 401k plan; those 50 and older can make additional catch-up contributions of $6,000. This money is not counted toward income, and all gains are tax-deferred.  The limits are the same for Roth 401(k)s, though the contributions do count toward income and all gains are tax-free.

For 2015, IRS clarified the ruling for after tax 401k treatment.  Essentially, allowing employees to contribute up to $53,000 for individuals in 2015.  Of the $53,000 limit, up to $18,000 can be pretax, the rest can be after tax, including any employer matching.  For example
  • $18,000 to 401k to reduce taxable income for the current year
  • Employer matching at $8000
  • Leaving $53,000 – $18,000 – $8,000 = $27000 for after tax 401k contribution
Since our household income make us ineligible for regular Roth IRA contribution other than backdoor Roth IRA, this allow me to set aside $27000 per year for tax free growth, it’s just awesome!

When to convert after tax 401k to Roth IRA?

Depends on the plan, Roth IRA conversion can take place one of two ways,
  1. anytime, the so called in place conversion.
  2. when you terminate my employment with your current company, either voluntarily or involuntarily.  Upon termination, you can convert my 401k into an rollover IRA.

If the place allows for in place conversion, do it once a year.  Starting in 2015,  the IRS has a rule which only allow once a year Roth IRA conversion.  Why do the conversion every year?  Because once the money is in Roth, my friend, you are in the tax free zone, no more taxes on earning or contribution.  Before the conversion, your earning are subject to tax, so you are better off converting your after tax 401k to Roth IRA as soon as possible.

If you don’t have in place conversion, then you will need to do the conversion whEn you leave the company.  Since your 401k will contain both pre tax and after tax contribution, you will roll over
  • the pre tax portion of 401k to a regular roll over IRA,
  • the after tax contribution to Roth IRA,
  • your earning on after tax 401k to regular IRA because the earning on your after tax 401k is still taxable.  This is why you want to convert as soon as possible.
Next year will be the first year I enroll in the after tax 401k program, I will report back with more details when I have first hand experience with this entire process.
Next blog I will discuss the topic of deferred executive compensation, another great way to save on taxes for high income earners.


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