Practical Cents #5: Creating More Tax-Free Savings for Retirement
High earners who quickly max out their 401(k) deferrals often assume they've hit a ceiling on tax-advantaged retirement savings. This video explains how some employer plans allow additional after-tax contributions up to a separate annual limit, and how converting those dollars to Roth status lets them grow tax-free going forward. The strategy, sometimes called the Mega Backdoor Roth, depends on the specific plan and requires the conversion step to actually happen.
High earners who quickly max out their 401(k) deferrals often assume they've hit a ceiling on tax-advantaged retirement savings. This video explains how some employer plans allow additional after-tax contributions up to a separate annual limit, and how converting those dollars to Roth status lets them grow tax-free going forward. The strategy, sometimes called the Mega Backdoor Roth, depends on the specific plan and requires the conversion step to actually happen.
Key takeaways
- Employer retirement plans have two separate limits: the employee deferral limit and the total annual additions limit.
- Many high earners max out the deferral limit but leave room under the higher annual additions limit unused.
- After-tax 401(k) contributions can fill the gap between what's already been contributed and the annual additions limit.
- Converting after-tax contributions to Roth status is the step that allows the money to grow tax-free, and it's easy to miss.
Hello everyone and thank you for joining me. High earners are constantly left wondering what's next after maxing out their 401(k) deferrals, often very quickly into the year. You've got this incredible tool to build your wealth, your income, but only a fraction of it can actually be put away into retirement accounts. You make too much to deduct contributions to a pre-tax IRA, but you also make too much to contribute directly to a Roth IRA. You feel like you've been penalized for working hard in your career and obtaining the income level that comes with it. How else can I put money away for retirement with tax advantages?
If your plan has it, the after-tax option is a game-changing way to get more money into retirement accounts. But not just any retirement account: Roth dollars. So, how does it work? To start, there are two limits for employer-sponsored retirement accounts: the deferral limit, what you as an employee can put away directly from your salary, and the annual additions limit, the total amount that can go into an employee's retirement plan at work. That second number, the annual additions limit, is the key, and where individuals are most likely missing out. You could be leaving tens of thousands of dollars that could make their way into Roth dollars left on the table each year. Compound that over your career and into retirement, we are now talking about millions of dollars that could be growing tax-free.
Say you make $250,000 and you've maxed out your 401(k), receiving a 3% company match. That's $32,000 that's been put into your 401(k) plan, leaving another $40,000 in room that could be put away before you reach the annual limit. Enter the after-tax contribution. The remaining $40,000 goes in like it would to an investment account or a savings account, after taxes have been paid on the deposit. But by converting those dollars to Roth, they're then growing tax-free for you and your loved ones. That second step is critical and can get left by the wayside as you're navigating through all the other priorities in your life.
Let's partner together to ensure that nothing is being overlooked and you're maximizing every opportunity to put money away toward retirement. Thank you for joining me, and until next time.
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