“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
The above quote is often attributed to Albert Einstein. It’s funny that a physicist rather than an economist or financier would pen such as succinct and pithy assessment of the power of interest and it remains just as true today as it did back then.
Today, the main vehicle for most American’s to save and build wealth in anticipation of retirement is through their employer sponsored 401K. First, a quick story about what a 401K can do for you: I work with a client who for decades worked as a janitor at a water treatment facility here where I live. He has no formal education and a pretty modest skill set, but among his skills are being a diligent saver and savvy investor. He never made over $45,000 per year even when he worked multiple jobs but retired 3 years ago at the age of 61 with over $1MM saved in his 401K! Between his investments and Social Security, he is actually able to spend more in retirement than he did when he worked (not to mention the early retirement)!
It’s difficult to overstatement the importance of effectively using your employer-based retirement plan benefits. In this post we will review the ins and outs of 401Ks, the differences between Traditional and Roth, how you can potentially save on taxes by optimizing your contributions and how to employ a little-known strategy to create a super Roth.
Traditional 401K
Formally defined,
“A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status) profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan under which an employee can elect to have the employer contribute a portion of the employee’s cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are generally not subject to federal income tax withholding at the time of deferral and they are not reflected as taxable income…” – Source IRS website
Informally, this means that a 401K is a type of individual saving/investing account set up through an employer that allows eligible participants to make tax deferred contributions directly out of their paycheck.
The key phrase here is tax-deferred which essentially means that the portion of your wages that you contribute to the 401K are not taxable to you in the year they are earned. This allows you to save on your tax bill upfront while simultaneously saving for your retirement. Furthermore, any income or growth that your money earns while invested in the 401K also grows tax deferred. Your account can conceivably continue to grow for decades and you won’t have to pay taxes until you withdraw those funds (usually in retirement, but not necessarily. More on that to come).
Roth 401K
With a Traditional 401K the key feature is that you can put money away on a tax deferred basis and receive tax deferred growth until you distribute the proceeds. But there is another variant of the 401K that enables you to do the opposite. Enter the Roth 401K.
A Roth 401K combines the increased contribution limits of a 401K (see below) and the tax benefits of a Roth IRA into a powerhouse for building wealth. Like with a Roth IRA, contributions made to a Roth 401K are taxed as income for the year in which the contribution is made. So even though you “saved” the money for retirement within your account it will still show up as taxable income come April 15th when you file your taxes.
But (and it’s a very big “but”) once the contribution is made, that money is not taxed again when you withdraw the funds in retirement. Furthermore, any growth that the account experiences is never taxed. Let that sink in. If you are willing to pay the taxes up front at the time of contribution, then you have the chance to earn tax-free growth and income that are orders of magnitude greater than what you contributed.
Employer Contributions
The IRS designed the 401K in such a way that employers and employees benefit from using it. One of the most important features is the Employer Match.
Under most plan designs, Employers will match a portion of the employee’s contribution to the 401K annually. A typical matching arrangement might be as follows:
- 100% for the first 3%
- 50% for the next 2%
What this essentially means is that the Employer will make a matching contribution equal to 100% of the first 3% of wages that the Employee voluntarily contributes to their account and will match at a rate of 50% for the next 2% of wages that the Employee contributes.
This might sound a little abstract so let’s work through a quick example. Suppose you make $70,000 per year as a car salesman/woman. You’re a good saver and are able to put away $10,000/year into your 401K. If your employer’s matching arrangement is the same as the one described above, then your match will work out as follows:
3% of your salary is equal to $2,100. 2% of your salary is $1,400. Your employer will contribute 100% of that first 3% to your 401K on your behalf so your match, in dollars, will be $2,100. They will then contribute 50% of the next 2% of your salary which is $700. In total, you will receive a $2,800 in “matching contribution” from your employer which is equal to 4% of your total salary.
An interesting way to look at the employer match is as a return on investment. If you put in $10,000 into this plan and your employer is matching $2,800 of that then your “instant” return on investment is 28%! Which, in case you haven’t heard, is a pretty good RoR!
A couple of things to note about the above example. Because you are contributing $10,000 per year to your 401K you are receiving the full available match from your Employer. If you were contributing significantly less, say $1000, then you would only receive $1,000 in matching contribution. Under most (but not all) plan designs your employer is not going to contribute more than you are so at minimum you should contribute enough such that you get the entire match that is available to you. In this specific case, you should contribute at least $2,800 so you then receive $2,800 in match and pocket that implied 100% return!
Additionally, keep in mind that matching applies regardless of whether you are contributing to a Traditional 401K or a Roth 401K, but all Employer contributions go into the Traditional (i.e. pre-tax) portion of your account. So even if all of your contributions are going into the Roth portion of your account, you will still accumulate some tax-deferred savings just based on what your Employer puts in.
Why do Employers offer a match? For the simple reason that it helps them dodge taxes (and who doesn’t like a good tax dodge?). The matching feature enables Employers to increase your compensation (potentially by a lot) without directly increasing your wages. The compensation you receive indirectly through the 401K is not considered wages which means that employers aren’t required to pay FICA taxes (Social Security, unemployment, etc.) on what they are “paying” you. This also explains why the portion they match goes into the Traditional/tax-deferred portion of your account; they aren’t going to match 4% of the salary and pay the taxes as that would defeat the whole purpose.
Contribution Limits
Like all retirement accounts, 401K’s are subject to contributions limits. For 2020, the maximum amount that an employee can contribute to their 401K (be it Traditional or Roth) is $19,500. If you are 50 or older however then you are also eligible to take advantage of catch-up contributions up to $6,500; effectively allowing those 50 or older to contribute $26,000. These limits are substantially higher than those available through IRA accounts which makes the 401K a more efficient savings vehicle.
| Age | Deferral Limit | Catch Up Limit | Contribution Limit |
| < 50 | $19,500 | $0 | $19,500 |
| >= 50 | $19,500 | $6,500 | $26,000 |
Note that the above limits only apply to contributions that you make; matching contributions from your employer are not subject to the limits shown above. However, there is a maximum total contribution that can be made to your account each year from all sources (both Employee and Employer). For 2020, the total amount that can be contributed to your 401K account is the lesser of $57,000 or 100% of your compensation. So, if your employer has a very generous matching scheme or a profit-sharing arrangement, then it’s possible that you could be constrained by this cap, but in practice I’ve never seen it come up.
Other 401K Features
In addition to the saving and matching features, 401Ks also have some unique features that can’t be found through other account types. Some of these features may be limited by the plan document that governs your plan, but it is worth contacting your Employer to see what benefits are available to you.
Loans: Most 401Ks allow for you to take a loan from your account up to the lesser of 1) 50% of the account value, or 2) $50,000. The loan duration can be for up to 5 years and the interest rate is typically competitive with market rates. The best part is that there is no underwriting involved so if you’ve built up a sizable account balance and need to access your account value then you can take a loan out usually within a few days. The loan amount is not taxable to you at the time it is made, and payments are taken directly out of your paycheck.
Distributions and Withdrawals
Because the 401K is designed to incentivize retirement saving, the rules that govern how to take money out of the plan are strict. Generally, distributions from your 401K cannot be made unless one of the following occurs:
- You reach age 59½.
- You have a financial hardship or an “immediate and heavy financial need”.
- The plan terminates and no plan is established to replace it (very rare).
- You die (tough…)
We’ll focus on circumstances 1 & 2 as they are the ones you are most likely to encounter and in the case of 4 you probably won’t care very much anyway.
The 59½ Rule
59½ is the magic age where the IRS considers you eligible to take distributions from our 401K for the purpose of funding your retirement. If you have been making pre-tax contributions, then you will be responsible for paying taxes on the amount you distribute from the account. Distributions are taxed at income tax rates just as if you had earned the income in your job. The below table shows the 2020 tax brackets for both single and joint filers. You can use this table to help determine what your taxable might look like in retirement.
Taxes are a crucial concept to keep in mind as you are saving for retirement because the balance you see in your account isn’t truly yours. In reality, only about 80% of the account value is yours and the other 20% belongs to the IRS. Time and again I’ve worked with clients who have $1MM in their retirement accounts and think they are set, only to realize that the money doesn’t go quite as far as they thought for this very reason.
However, if you have been making Roth contributions your whole career then now is the time to reap the rewards of your hard efforts as the money that you are taking out will now all be tax-free! Furthermore, distributions from Roth 401K don’t even count toward your income so if you have income from other investments (other accounts, real estate, etc.) then your tax bracket might end up being very low and you can still live a very nice lifestyle.
Distributions Before 59½
Distributions before age 59½ are technically permitted under IRS rules…but I wouldn’t advise it. The IRS really wants you to use this money for retirement and as such levies a 10% penalty on all distributions taken prior to age 59½. This is in addition to the taxes that you will be responsible for paying as a result of the distribution. So, if your effective tax rate is 20% and you take $100,000 out of your 401K then you will be taxed $20,000 and be assessed the $10,000 in penalties. In the end you’ll net $70,000 which is a heavy price to pay to get your money out unless you absolutely have to.
If your account is Roth, then you can make a withdrawal and not be required to pay taxes but are still subject to the 10% penalty.
Exceptions to the 59½ Rule
Like with any rule, there is always an exception and the 59½ Rule is no different. The IRS offers a limited set of exemptions that allow you to withdraw funds from your 401K even if you have not reached age 59½ without incurring the 10%. The two that are most relevant are:
- Disability: In the event that you become totally and permanently disabled, then you can take a distribution from your 401K without incurring a penalty.
- Reimbursement for Medical Expenses: If you have significant medical expenses in a given year that your insurance will not cover, then the IRS permits you to take a withdrawal from your 401K as reimbursement. The expenses have to be substantial and must exceed 7.5% of your adjusted gross income for the year and only then can you reimburse yourself for the amount over 7.5%, but if you’re in a bind know that this option is available to you and that you won’t be charged a penalty.
Some other exceptions exist to the 59½ Rule, but they are even more narrow in scope than the ones described above. For more information on this topic, the IRS has put together a nice table that you can reference here.
Hardship and Immediate Financial Need
The IRS defines 6 specific events that qualify an employee to take a withdrawal from there 401K account; these are known as “hardship withdrawals”. The 6 qualifying events are as follows:
- Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary. (Notice how this ties in with the limited exemption for reimbursement of medical expenses described above).
- Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments); down payment, closing, etc.
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary.
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
- Certain expenses to repair damage to the employee’s principal residence.
The IRS is very strict about the hardship meeting one of the above definitions and limits the amount taken to the minimum amount required to ameliorate the problem.
Hardships are a bit of a strange animal as they are a defined set of circumstances that allow you to take a distribution from your account, but don’t contain any special provisions or leniency for doing so. Hardship distributions are still subject to taxes and the 10% early withdrawal penalty. Essentially hardship allows you to get money out of your account, but at significant cost. For more information on hardship distributions, please reference the IRS website here.
Tax Optimization Tips and Tricks
By now we have gone through just about everything you need to know about how the 401K works. Now we turn to the question of how to make it work better for you via tax-optimization. Tax optimization is really just a forecasting procedure to help you determine where you should put your money in your 401K; whether it should be Traditional or Roth. The goal is to optimize the way you make contributions such that you limit your current and future tax liability and keep more of the money you earned!
I’ll just state up front that tax optimization requires some witchcraft. By this I mean that because there so many variables at play when planning for the future, you’re inevitably going to have to make some guesses based on very limited information and the end result is highly uncertain.
The basic theory goes like this:
Early on in your career you likely will start in an entry level position making a pretty low salary. You likely will not have significant assets that produce income. Consequently, your tax bracket will be quite low, and you’ll be paying very little in tax (or perhaps none at all). At this point in your career you’ll want to contribute primarily to the Roth portion of your 401K. Since your income is low, the additional taxes that you’ll have to pay on your Roth contributions will also be low. This will allow you to get money into your Roth very cheaply and allow it to grow tax free for as long as possible.
Later in your career as you acquire better skills and move into more complex and better compensated positions your tax bracket will be higher and you may have acquired assets that provide you with income. As a result, your tax liability each year might be substantial, and it may become quite expensive to contribute to your Roth. Since you’re earning a high income you can benefit from a tax break now by contributing to the Traditional portion of your 401K. This reduces your taxable income up front and allows the money to grow tax deferred. In retirement you likely will not be earning as high of an income so your tax bracket will be lower. When you withdraw money from your Traditional 401K you can effectively save on the taxes you pay just because you are in a different stage of life.
In the eyes of the IRS, money withdrawn from a Traditional 401K is viewed as income while income withdrawn from a Roth 401K is not. Optimizing how you take money out of your accounts can help reduce your taxable income and may reduce the amount of taxes withheld from your Social Security payments and the premiums you pay for Medicare.
The Mega Backdoor Roth Contribution
By now we have reviewed the features of 401Ks, discussed why tax optimization is important and how to approach it. We’ll conclude this article by going over a powerful strategy that leverages all the features of a 401K and gives you the opportunity to build up a very large Roth balance in almost no time. Enter the Mega Backdoor Roth Contribution!
The Mega Backdoor Roth Contribution, henceforth known as MBRC, is a mechanism that allows you to convert a portion of your 401K balance into a Roth balance and effectively allocate more money to the Roth portion of the account than what the contribution limits explicitly allow for. In order to use the MBRC your plan must have two specific features:
- Allow for After-Tax contributions above and beyond the Pre-Tax contribution limit (see table from earlier).
- Allow for in plan Roth conversions.
Despite the name, After-Tax contributions are distinct from Roth Contributions and it’s important to understand to use this strategy correctly. Roth contributions are taxed when the contribution is made and grow tax-free thereafter. After-Tax contributions are similarly taxed, but the money grows tax-deferred rather than tax-free. An employee might consider making After-Tax contributions if they had already maxed out their pre-tax contribution for the year but had extra income that they wanted to save and wanted to take advantage of the tax-deferred feature. The After-Tax contributions give you a partial benefit of tax deferred growth, but the tax up-front is unavoidable.
Recall that the maximum total amount (i.e. from all sources) that can be contributed to your 401K in a year is $57,000 for 2020. As an example, let’s say that you are maxing out your pre-tax contributions of $19,500 and your employer is matching you an additional $6,000 which gives you a total of $25,500 going in pre-tax. You would then have an additional $31,500 to contribute after-tax.
After you have made your After-Tax contribution, it’s time to convert those funds into a Roth using the in-plan Roth conversion feature. An in plan Roth conversion is basically what I sounds like: it allows you to convert cash from one pool (pre-tax and after-tax) in a Roth while keeping the money in your plan. You are taxed at the time of the conversion, but afterward the money grows tax-free.
You can probably see where I’m going with this: if you are a high-income earner and can save a substantial sum to the after-tax portion of your 401K, then you can use the conversion feature to build a sizable Roth 401K account very quickly. In the case of the above example, you could convert the full $31,500 into Roth which effectively allows you to “contribute” more to the Roth portion of your 401K than IRS rules explicitly allow for. If you do it in the year that the contribution is made, then you will be doing it all with after-tax dollars and will not be taxed again upon conversion. If you have after-tax money that is grown, then you can still do the conversion, but will have to pay some tax on the tax-deferred “growth” portion.
Pretty cool right!
A Step By Step Process For Doing A Mega Backdoor Roth 401K Conversion
Remember, that your plan must have the two features from above. In addition, it’s best practice to work with your tax advisor and HR/plan provider very closely. The rules for doing a MBRC are very precise and you must be careful to do it correctly.
- Maximize Your After-Tax 401k Contributions
The first step for the Mega Backdoor Roth Contribution is to figure out how much you should contribute to maximize your after-tax 401k contributions.
This means understanding your employer’s plan, and then making the additional contributions. This can be a challenge because many plans deduct contributions directly from your paycheck each pay period rather than lump sum. If you want to use the MBRC, then you’ll need to start thinking about it early in the year and make the appropriate adjustments. You also want to make sure that these contributions are AFTER-TAX, NOT Roth 401k contributions.
2. Process In-Plan Conversion to Roth 401K Account
Work with your 401K provider to process the in-plan conversion to Roth. There is a good chance you can just do this online with the click of a button, but you need to be careful to ensure source of funds is AFTER-TAX money. If you mistakenly use your pre-tax money, then you’re not going to reap any of the benefits.
Wrapping Up
In this post we covered A LOT of ground! We learned all about the rules governing 401Ks: how much you can contribute, how matching works, what differentiates Traditional from Roth, and other 401K features such as hardship withdrawals and how to take a loan. We reviewed tax optimization and how it can be used to optimize your retirement saving when you are young and withdrawals in your retirement. Finally, we introduced the Mega Backdoor Roth Contribution strategy that the high-income earner can use to build up tax-free savings.
Planning for retirement ain’t easy! Hopefully after reading this you are armed with new knowledge and tools for getting the most out of your 401K.
Until next time, thanks for reading!
-Aric Lux.
