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Many people know about their 401(k) perks, but their plan may have a hidden feature that allows for even more savings.
When someone maxes out their 401(k) — $19,500 in annual contributions for those under 50 in 2021 — some plans may permit them to stash more money into their account.
After-tax 401(k) contributions may let someone actually save up to $58,000 in 2021, including employer matches, profit sharing and other plan deposits.
Later, investors may use a so-called mega-backdoor Roth maneuver, paying levies on after-tax earnings, to move the money into a Roth individual retirement account.
“It can be a really really powerful technique for the right individual,” said certified financial planner Dan Galli, owner at Dan J. Galli & Associates in Norwell, Massachusetts.
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By rolling the money into a Roth IRA, investors may start building a tax-free pot of money for retirement, without rules to take the money out at a certain age.
“If they’re young enough and have years of tax-free growth ahead of them, it could be a game-changer,” said JoAnn May, a CFP and CPA with Forest Asset Management in Berwyn, Illinois.
After-tax vs. Roth 401(k) contributions
It’s easy to confuse after-tax 401(k) contributions with a Roth 401(k) account since both allow employees to save money after taxes, but there are significant differences.
For example, employees under age 50 may defer up to $19,500 of their salary into their company’s regular pre-tax or Roth (after-tax) 401(k) account.
However, you can make additional after-tax contributions to your traditional 401(k), which allows you to save more than the $19,500 cap.
For example, if someone defers $19,500 and their employer deposits $8,000 for matches and profit-sharing, they may save another $30,500 before hitting the $58,000 plan limit.
If they’re young enough and have years of tax-free growth ahead of them, it could be a game-changer.
JoAnn May
Financial planner at Forest Asset Management
The other twist is how earnings are taxed. While Roth 401(k) withdrawals (including earnings growth) are tax-free in retirement, any earnings on those “bonus” amounts are taxed. Yes, it’s confusing.
“That’s why it’s important to get [after-tax contributions] out of the 401(k) plan periodically,” said May.
Once per year, her clients withdraw after-tax contributions and earnings and roll the money into a pre-tax or Roth IRA. The downside of the Roth IRA option is there may be a tax bill on growth at the conversion.
Keep in mind the feature isn’t available for all plans.
While many 401(k) offer Roth accounts, after-tax contributions are less common. Fewer than 20% of 401(k) plans provided after-tax contributions in 2019, Vanguard reported.
Moreover, plans with after-tax 401(k) contributions may not educate employees about the option. In some cases, advisors may discover the feature buried deep within a client’s benefits paperwork.
“The most important thing is to read your employee benefits handbook and pass it on to your advisor,” said May.
Taxable income in retirement
Whether someone leverages after-tax or Roth contributions, tax-free money may be valuable in retirement, said Galli.
When clients apply for Social Security, their portfolio income may hurt those benefits. Retirees may pay income taxes on up to 50% to 85% of their Social Security payments, depending on their modified adjusted gross income.
About 40% of those who receive Social Security income pay taxes on their benefits, according to the Social Security Administration.
Some retirees may also pay more for Medicare premiums. While most retirees don’t pay for Medicare Part A, the base price for Medicare Part B starts at $148.50 for 2021.
Depending on their income, retirees may have to pay more for Medicare Part B, with top earners paying monthly premiums of $504.90.
Source : CNBC
