In 2021 anyone with any level of income can save up to $19,500 in a pre-tax or Roth 401(k) or similar retirement plan, and if you're 50 years of age or older, you can put in an additional $6,500, as a catch-up contribution, for a grand total of $26,000.
If you still have additional funds that you want to save, with a potential tax advantage, you may want to consider making "after-tax contributions" to your 401(k) if your company plan allows it.
And most importantly you may be able to convert these funds to a Roth IRA, even if you earn too much money to buy one.
To better understand how this works, it helps to know the similarities and differences of contributions to a Roth 401(k) and after-tax contributions put in a regular pre-tax 401(k).
In both cases the contributions are made with after tax money, which means these funds are not sheltered from taxes.
The contributions to a Roth 401(k) are made as part of your $19,500 maximum allowable contribution to the 401(k) plan ($26,000 for those 50 and older) and the earnings in the Roth 401(k) grow tax-free.
This means upon making a qualified withdrawal, both the initial contributions and any earnings are forever sheltered from tax.
On the other hand the “after-tax” contributions are not part of the $19,500 ($26,000 for those 50 or older) that all qualified participants are allowed to put into their 401(k).
Instead they are “in addition” to these initial contributions and their earnings are not tax-free, but tax deferred with taxes owed upon withdrawal from the plan. These contributions can only go into the pre-tax 401(k).
The reason you can put in these additional after-tax funds, is because the IRS allows a total of up to $58,000 to be saved in a 401(k) plan for 2021 ($64,500 for those 50 and older).
This includes your initial $19,500 contribution ($26,000 for those 50 and older), any matching or profit sharing made by your employer, and finally your after tax contributions, until your combined total from these sources gets you up to the $58,000 ($64,500 for those 50 and older).
The silver lining in making these after-tax contributions is that it’s very likely you will be able to roll them over to a Roth IRA, or in some cases to a Roth 401(k).
This would then put you in a position where all the future earnings would be tax-free instead of being fully taxable upon withdrawal. In essence turning it into a giant Roth IRA.
As a simple example, let's say Bill is 60 years old, married filing a joint return with income over $208,000, which means he makes too much money to buy a Roth IRA.
Because he’s 60, he qualifies to do the $6,500 catch-up, so Bill could make elective deferrals into his retirement plan of up to $26,000, either in a Roth 401(k) or a regular pretax 401(k).
Let’s assume Bill’s company plan does not offer a Roth 401(k) so he puts $26,000 into a regular pretax 401(k) for the year.
Now, let's say that Bill's employer, between a company match and profit-sharing, adds another $10,000 on Bills behalf, which now gives him a total of $36,000 for the year.
Since the IRS allows up to $64,500 to be saved in a 401(k) for someone 50 or older, this still leaves an additional $28,500 that Bill can put into his 401(k) plan, as after-tax contributions, if his company makes this option available.
Where this creates an opportunity to make a huge Roth IRA contribution, is through the use of an in-service withdrawal which is allowed by about 70% of company plans.
An in-service withdrawal occurs when an employee takes a distribution from a company retirement plan such as a 401(k), while still working for their company, and in this case, rolls it over to an IRA.
This may occur any time after the employee reaches age 59 1/2. You can verify if your plan offers such withdrawals by requesting a copy of the summary plan description.
Most company plans would allow Bill to do a partial rollover of only his after-tax contributions and any earnings attributed to these contributions. He could roll the after-tax money to a Roth IRA and the pre-tax earnings to a traditional IRA and avoid creating any taxable income.
While Bill made too much money to buy a $7,000 Roth IRA, by making after-tax contributions to his 401(k) and then rolling them over, it allowed Bill to put $28,500 into a Roth IRA. What a deal for Bill.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. IRA’s and ROTH conversions require understanding of specific rules, for complete rules on IRA’s (including who qualifies), please visit www.IRS.GOV Publication 590a or consult with a qualified professional