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.
- $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
When to convert after tax 401k to Roth IRA?
- anytime, the so called in place conversion.
- 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.
- 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.