In addition to 401(k) plans, there are after-tax plans known as Roth plans. The benefits of a Roth IRA are that withdrawals are tax-free, there is no age 70 1/2 required minimum distribution rules, and they add tax diversification to your retirement plans. Roth IRAs are not new. Many wage earners had Roth IRAs years ago, but then careers outpaced the income limits.
The strategy for funding a Roth IRA when income exceeds limits is possible though. It is commonly referred to a Backdoor Roth IRA, and can be applied as follows:
1. Max out your tax-deferred 401(k) contribution of $18,000 (maximum contribution for wage earners younger than 50 years old).
2. Calculate your maximum after-tax contribution: Defined-contribution limit of $53,000, less pretax contributions, less the total of all employer contributions.
3. Perform at least annual in-service distribution rollover requests of your after-tax contributions to a Roth IRA.
It is important to note that not all companies offer a Roth IRA. So to comply with IRS rulings, 401(k) plan documents and 401(k) plan administrators need to be set up to allow for the following:
1. Post-tax contributions
2. In-service withdrawals
3. Separate accounting for all contribution types
In addition, plan discrimination testing will need to support your ability to max out your defined-contribution limit.
This is completely different from another Roth—the Roth 401(k). In a Roth 401(k) you make contributions after tax (not taking the immediate tax savings) and the earnings from all employer contributions will be taxable. The 401(k) strategy makes sense for individuals looking for tax diversification because the long-term tax rates and structure are uncertain.
Before you file away your taxes for the year, take a close look at your W-2 and see what your year-long retirement contribution is. If you maxed out your 401(k) contributions, good for you! But before you congratulate yourself on a job well done, look at other options available for additional retirement savings that may affect your tax bill in the future.
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