Employer Retirement Plan Backdoor Roth Conversions
January 13, 2023One increasingly popular strategy we have seen is the backdoor Roth conversion through an employer’s workplace retirement plan. If your employer’s plan allows, this strategy will enable you to convert after-tax voluntary 401(k) contributions to a Roth 401(k). When is it a good idea to contribute to an after-tax voluntary 401(k) and convert to a Roth 401(k)? Here are some factors to evaluate if you are considering this strategy:
- Your plan allows after-tax voluntary contributions, and you want to save more than the pre-tax/Roth 401(k) 2024 elective deferral contribution limit of $23,000 or $30,500 if you’re over 50 years old.
- You have a fully-funded emergency savings account, a reasonable debt situation, and do not need the liquidity.
- You make too much to contribute to a Roth IRA but still want to save Roth dollars for your retirement.
- You don’t want the hefty tax bill of a taxable conversion of pre-tax to Roth.
- And most importantly, you love TAX-FREE money for your retirement!
The Basics
At a fundamental level, converting after-tax voluntary 401(k) money to a Roth 401(k) allows employees to save significantly more, tax-free, for retirement.
You don’t get a current-year tax deduction for the money deposited after-tax and then converted to a Roth 401(k), but the funds grow and are distributed tax-free as long as you hold the account until the age of 59.5 and it has been 5 years since your initial contribution into the Roth 401(k).
After-tax Voluntary Contributions in Work Retirement Plans
Some employer retirement plans allow employees to make three types of contributions 1) pre-tax, 2) Roth, and 3) after-tax voluntary. After-tax voluntary contributions have already been subject to income tax.
Generally, employees can contribute up to $23,000 (plus a $7,500 catch-up contribution if over 50) to their pre-tax and/or Roth portion of the 401(k) in 2024. The combined annual IRS contribution limit is $69,000 in 2024 for most employer-sponsored retirement plans.Further, if your plan allows it and depending on whether your employer contributes or not, you may be able to make after-tax voluntary contributions above the basic limit.
It’s a good idea to work with your retirement plan administrator to find out exactly how much you can contribute (if the plan allows) to the after-tax voluntary account, but to get an idea, use the following equation:
| After-tax Contribution Equation | ||||||
| $69,000 is the IRS limit in 2024 | Minus | Pre-tax and/or Roth Contribution $23,000 (+$7,500 if over 50 years) | Minus | Employer Contribution(Discretionary and/or Non-Discretionary) | Equals | Potential After-tax voluntary Contribution Allowable |
Backdoor Roth 401(k) Conversion
In addition to contributing to the after-tax voluntary portion of your 401(k), your company’s plan may allow you to convert this contribution to your Roth 401(k). You may be able to contribute up to $46,000 in 2024 of after-tax voluntary dollars and then convert all of it to your Roth 401(k)! That’s right – up to $46,000 growing tax-free for retirement. Some plans also allow you to roll this money outside the plan via a rollover to a Roth IRA.
What if my 401(k) Doesn’t Allow an In Plan Conversion?
If your plan doesn’t allow the backdoor option while working, you’ll have to wait until you separate from your employment. Typically, you can then roll after-tax voluntary contributions to a Roth IRA and after-tax voluntary earnings to a pre-tax Traditional IRA account, or you can convert the earnings and pay tax on that portion of the conversion.
Example
Henry has a great job as a software engineer. He earns a significant income and lives a simple life. He maxes out his pre-tax contribution to his 401(k), which is $23,000 in 2023, and his company contributes $9,500. Henry also contributes an additional $36,500 to the after-tax voluntary portion of his 401(k).
| After-tax Contribution Equation Example | ||||||
| $69,000 is the IRS limit in 2024 | Minus | Pre-tax and/or Roth Contribution $22,500 (+$7,500 if over 50 years) | Minus | Employer Contribution(Discretionary and/or Non-Discretionary) | Equals | Potential After-tax Voluntary Contribution Allowable |
| $69,000 | – | $23,000 | – | $9,500 | = | $36,500 |
His retirement plan allows him to convert the after-tax voluntary contributions to his Roth 401(k). In fact, if his plan allows, Henry can set up his conversions to happen automatically as soon as he contributes his after-tax voluntary dollars. He continues to convert the money to his Roth 401(k), building up tax-free funds for retirement.
Conclusion
The 401(k) Backdoor Roth Conversion is an excellent opportunity to save more for retirement in your 401(k) than the pre-tax and Roth contribution limits will allow. It makes the most sense for those who already have a stable financial foundation and do not anticipate liquidity needs before retirement.
Notes
* There are always exceptions to the rules, so before conversion, seek advice from a tax expert that will help you understand the conversion’s tax implications to your specific situation.
* There may be plan-specific rules. Please check with the administrator for your workplace retirement plan.
* There are different distribution rules for after-tax voluntary contributions made before 1987. Consult your tax advisor for more information.
* Conversions may affect net unrealized appreciation (NUA) treatment on employers’ stock positions.