How to Super-Fund a Roth IRA

You can use after-tax 401(k) contributions to save significantly more for your retirement and reap the tax advantages of a Roth.

There is good news for people who work and contribute to a 401(k) retirement plan. Because of a recent Internal Revenue Service ruling, anyone making after-tax contributions to these plans can often turn this money into tens, and possibly hundreds, of thousands of income tax-free dollars when they quit their job or retire.

Most workers are familiar with 401(k) retirement plans. As of 2016, people can contribute up to $18,000 annually to these plans—or $24,000 annually for those over age 50—to defer taxes until this money is withdrawn in retirement.

But some companies also allow workers to make after-tax contributions to their 401(k) retirement plans in what is called an "after-tax account." For the senior-level manager or executive looking to retire in a few years, or leave for another job, the money in these after-tax accounts can generate a significant amount of tax-free income for them in retirement. That's because the IRS ruled in late 2014 that a person's after-tax contributions can now be rolled directly into a Roth IRA and avoid tricky tax issues. In other words, you can effectively "super-fund" a Roth IRA once you leave your employer.

Here's an example of how this strategy can work. Let's assume you make the following contributions:

  • Annual Pre-Tax contribution to 401(k): $18,000
  • Annual Pre-Tax "catch up" contribution (50 and older): $6,000
  • Employer Match (varies by employer): $9,000
  • Annual After-tax employee contribution $26,000

Once you leave your employer, your $26,000 in after-tax contributions can be rolled into a tax-free Roth IRA. By taking this step, you have effectively quadrupled the amount of money in future tax-free Roth retirement assets compared with the standard method of funding a Roth IRA. In 2016, annual contributions to Roth IRAs are limited to $5,500 for anyone under age 50 and $6,500 for those 50 and older.

Of course, the benefits really add up the longer a person contributes to their after-tax account in their 401(k) plan. For example, a person putting aside $26,000 in after-tax contributions annually for five years will have saved $130,000—not counting any appreciation. If the same person (who is over the age of 50) made maximum annual contributions directly to a Roth IRA, they would only have $32,500. That's a difference of nearly $100,000.

The after-tax contribution strategy also has other significant advantages. First, there are no earned income limitations on contributions to an after-tax 401(k) account; anybody, even those earning $1 million or more annually, is eligible. On the other hand, to contribute the maximum to a Roth IRA, you must earn less than $117,000 annually, if single, and $184,000 if married filing jointly. (Certain phase-out limits apply for incomes above these levels). This after-tax 401(k) strategy presents an opportunity for high-income individuals to significantly build income-tax free assets in a Roth IRA.

Next, a person contributing to an after-tax 401(k) account can still make the maximum contribution to their company's pre-tax 401(k) account, enabling those 50 and older to defer up to $24,000 annually, while still making after-tax contributions to their plan. There is a limit, of course, on how much money can be poured into these two accounts each year: $53,000 for people under age 50 and $59,000 for those age 50 and older. These totals include money contributed by the employee and the company.

Finally, even if your company has discontinued its after-tax contribution provision in recent years, those who have funded after-tax dollars in previous years can take advantage of the Roth IRA strategy once they leave their employer.

I've advised several of my clients to take advantage of this super-funded Roth strategy. Here's a good example: One of my clients recently retired at age 65 and had accumulated more than $350,000 in lifetime after-tax contributions. We took all of this money and rolled it into a new Roth IRA. It would have taken him more than 50 years—longer than his entire working career—to deposit that much in a Roth IRA at today's limits.

If your company offers this benefit, high-income taxpayers should make it a point to start funding, or keep funding, after-tax contributions into their 401(k) plan. It will enable you to accumulate more assets in a tax-efficient manner for retirement.

Lisa Brown is a partner and wealth adviser at Brightworth, an Atlanta wealth management firm. She specializes in investment management, executive compensation, retirement transition and estate planning.

About the Author

Lisa Brown, CFP®, CIMA®

Partner and Wealth Advisor, Brightworth

Lisa Brown, CFP®, CIMA®, is author of "Girl Talk, Money Talk, The Smart Girl's Guide to Money After College." She is the Partner in Charge for corporate professionals and executives at wealth management firm Brightworth in Atlanta. Advising busy corporate executives on their finances for nearly 20 years has been her passion inside the office. Outside the office she's an avid runner and supporter of charitable causes focused on homeless children and their families.

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