With the threat of higher taxes on the horizon taxpayers are increasingly looking for ways to hedge that risk in retirement. This is especially true for those who have participated in an employer-sponsored retirement plan at their workplace for many years or even decades.
For many savers most, if not all, of their retirement savings are held within traditional, pretax accounts. Roth contributions within employer plans became available in 2006. But it has taken years for plans to add this feature and for participants to begin utilizing it as an option for a portion of their salary deferrals.
Of the $40 trillion retirement assets (ICI, Sept 2024), Roth accounts reflect a relatively low percentage of the overall total.
So, how can those who are still working and participating in an employer plan save more in Roth accounts without negative tax consequences on their current tax bill?
One strategy is to determine if your defined contribution plan allows voluntary, after-tax contributions into the plan. These are different from Roth 401(k) contributions made through salary deferrals. Voluntary after-tax contributions can be made in excess of your maximum salary deferral into the plan ($23,000 for 2024 not including catch-up contributions for those age 50 or older).
A benefit of making after-tax contributions within the plan (in excess your maximum salary deferral) is that these contributions, depending on specific plan guidelines, may be transferred to a Roth account within the plan, or directly transferred out of the plan to a Roth IRA. Since these are after-tax contributions, there is no tax when moving them from the after-tax portion to a Roth account. This action is sometimes referred to as a “mega backdoor Roth strategy.” It may be effective for higher earners who are maxing out their 401(k) plan to significantly fund a Roth account, even though their income restricts them from directly funding a Roth IRA. For 2024, income phaseouts on Roth contributions apply once modified adjusted gross income exceeds $146,000 for single filers and $230,000 for married couples filing a joint return.
Consider this example:
- Joan has participated in her 401(k) plan for many years making traditional, pretax contributions while also receiving employer matching contributions, also made pretax. While she is pleased with the sizeable savings within her plan, she is concerned about the impact of taxes when she begins distributions in retirement.
- This year, she is contributing the maximum amount of $23,000 (not including the catch-up contribution) into the plan through salary deferral. Because she is in a relatively high tax bracket, she is making pretax contributions.
- She receives a total employer contribution (match + profit sharing) of $16,000.
- The total of her own salary deferrals plus employer contributions totals $39,000.
- If her plan allows, Joan could contribute an additional $30,000 in after-tax dollars into the plan (up to the annual limit for all plan contributions of $69,000 for 2024).
- Pursuant to plan rules, Joan could transfer those after-tax contributions to either a Roth account within the plan, or a Roth IRA outside of the plan (participants must refer to the plan document for more details on options available to them).
In this example, Joan has effectively made a higher contribution to a Roth account $30,000) than is allowed within an IRA ($7,000 limit for 2024) without being restricted by her higher income level, which would not allow a Roth IRA contribution in her case.
Tax planning in retirement
For those who are “overweight” traditional, pre-tax retirement assets, this type of strategy can help to create some diversification by tax status. When drawing income in retirement, this may allow for more choice on where to draw funds from depending on the current tax environment, and personal tax circumstances. For example, if facing a lower tax bracket in a certain year, it may be advisable to withdraw more funds from a traditional retirement account to take advantage of lower tax rates. Conversely, if a higher tax bracket applies, it may be more advisable to withdraw from a Roth account if additional income is needed. It’s important to note that many retirement plans do not offer the option of making voluntary, after-tax contributions into the plan. Depending on the plan’s characteristics, these types of extra after-tax contributions can lead to issues with discrimination tests required of ERISA plans if a high proportion of highly-compensated employees are taking advantage of this feature.
Seek professional advice
Since individual circumstances will vary widely, it’s important to work with an advisor knowledgeable of managing income and taxes in retirement, who is also aware of your personal financial situation and objectives. For those who require modest income in retirement and expect to be in a low tax bracket, holding funds in a Roth account may not make sense. But for many, having a mix of traditional, pretax retirement funds and Roth savings can provide more flexibility to manage taxes in retirement.
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