America: (Roth) 401k and IRAs
Hey! Before we start, just note that all these account types are simply containers for money. You need to actually do something with that money by putting it into some kind of market-based fund, or it will simply sit there as cash. Don’t come back in a few years and wonder why your money hasn’t increased because you forgot to invest it. Simply making 401k/IRA contributions is not enough.
tl;dr
- The various 401k and IRA plans are a powerful tax advantaged tool to be used during retirement, but are subject to the annual contribution and/or income limit
- Using various backdoor methods, you can bypass some of these restrictions up to a higher limit, allowing you to supercharge your retirement
Employer Account Types (401k)
Since 401k plans are sponsored by your employer (as they must be funded through payroll), I will only be including the two most common types of 401k. There exist other types, such as the SIMPLE 401k for small businesses, but feel free to read the IRS publication on your own time if you’re interested in learning about those.
If you, y’know, have nothing better to do.
There are no income restrictions to contribute to any type of 401k. The maximum contribution to the Roth and Traditional in total is $20,500 for 2022. These limits change every year.
Roth 401k
The Roth 401k allows you to make after-tax contributions which can be withdrawn tax-free when you retire. If your tax bracket is currently very low, you might want to consider the Roth 401k as your tax bracket in retirement may be likely to increase. Conversely, if your tax bracket is currently high, a Traditional 401k might be more worth it if you plan on being in a lower tax bracket during retirement.
Disclaimer: When I say “high tax bracket” I don’t mean your current income. The Roth 401k may make sense in some situations even if you are a high-income earner. For example, if you are in a low-tax state and intend to retire in a high-tax state, you may wish to consider the Roth.
Traditional 401k
The Traditional 401k is a powerful investment tool that allows you to deduct contributions made from your tax return and pay tax on withdrawals in retirement. That is, contributions made are tax-deferred until retirement. This is usually suited towards investors that will have a lower tax bracket when they retire.
To grossly oversimplify, as a high income earner you will save a lot of tax now and pay a little bit of tax later when you retire.
Of course, if you plan on having a lot of income when you retire, the Roth 401k might be a better choice.
After-tax 401k
This is a little bit of a strange 401k account type. You might have seen this option in Fidelity or similar retirement platforms, if your employer supports after-tax contributions to a 401k. It may also be labelled as “post-tax”. Contributions made to this account are… after-tax.
Duh.
The earnings in this account are taxable as income upon withdrawal, but the contribution can be withdrawn without tax (as they have already been taxed).
The contribution limit to the After-tax 401k is not a defined number, but actually the difference between $61,000 (in 2022) and the sum of Roth & Traditional 401k contributions made by you and your employer.
For example, if you contribute the maximum $20,500 to a Traditional 401k, with an employer match of $5,000, the contribution room for the After-tax 401k would be $61,000-$20,500-$5,000 = $35,500. If your employer did not match contributions, the limit would instead be $61,000-$20,500 = $40,500
The large amount of room in this account means that many will struggle to maximize contributions. Assess whether this option is right for you, especially if you have upcoming large purchases such as a car or house.
This feels like the worst option of the three, as it is not tax advantaged whatsoever. Why would you want to contribute to the after-tax account? More on this later.
Computing Maximum Contribution Amounts
You may be wise to maximize the amount of money you contribute to the 401k accounts. In my (limited) experience, plan providers only allow for contributions in the form of a percentage of your income, which can be especially confusing if you’re starting in the middle of the year.
The following ignores the After-tax 401k account.
If you are making pre-tax/traditional contributions for a full year, it’s fairly simple to divide the contribution limit of $20,500 by your gross income, say $80,000. This would result in a per-paycheck contribution of about 26%.
If you are making Roth contributions for a full year, the math becomes slightly more complicated. I would recommend waiting to see how much tax is withheld from your paychecks to get your average tax rate, then performing a similar computation above on your net income and generously rounding up for any inaccuracies. For example, if your average tax rate is 23%, reducing a gross income of $100,000 to a net income of $77,000, you you would divide the contribution limit of $20,500 by $77,000, giving a per-paycheck contribution of 27%, generously rounded up (arbitrarily) to 30% or 35%. I round generously because computing your tax bracket is difficult until you file your tax return, after which point you can no longer make 401k contributions.
If you are starting in the middle of the year and wish to maximize your pre-tax/traditional contributions, slightly more math must be performed. Roughly, divide your gross full-year salary by the number of pay cycles in the year, and multiply by the number of remaining pay cycles in the year. This should give your remaining income for the year. Divide the contribution limit by your remaining gross pay to give the contribution percentage. For example, a salary of $100,000 in a standard biweekly pay cycle would have 26 paychecks each year. If 8 pay cycles remained in the year, that would leave about $30,769 of gross income to be paid out through the end of the year. To maximize contributions, you would need to contribute at least 67% of each pay check towards your 401k.
Yikes!
A Graphic
- Contributions to a Traditional/Roth 401k go into the same “bucket” of the $20,500 limit, allowing you to mix and match amounts into either account up to the limit
- Your employer may or may not match your contributions. Usually this is some percentage of your contribution up to some limit that they are willing to contribute. Theoretically, they could match 100% of your contributions, but I think you might struggle to find an employer willing to do this.
- The After-tax 401k can be filled with any remaining room, up to $61,000.
Individual Account Types (IRA)
For this article at least I’ll only cover as much detail as necessary to understand how rollovers, in-plan conversions, backdoors, mega backdoors, and other fancy financial fanagling thingamajigs can work to help you out. How you choose to invest the money in these types of accounts is ultimately up to you, and I have no opinion on the matter.
None that would matter, anyways.
These accounts are known as Individual Retirement Accounts, or IRAs.
Note that the maximum amount you can contribute to all of your IRAs in total is $6,000 in 2022. This changes every year, so be sure to double check!
Roth IRA
The Roth IRA is a type of account where you contribute post-tax money to be grown tax-free, and withdrawn tax-free in retirement. The IRS lets you withdraw any earnings tax-free as you already paid tax on the money initially used to fund the account, meaning they already got their share.
Because of its powerful tax advantage, the IRS places strict limits on how much you can make and how much you can contribute to a Roth IRA each year.
For the Canadians, the Roth IRA most resembles the Canadian TFSA, with a few restrictions. The Americans would also do well to note the points below:
- Roth IRA earnings (ie. gains) cannot be withdrawn (without penalty) until 59.5
- Roth IRA earnings cannot be withdrawn (without penalty) until after 5 years have passed since your first contribution was made
- Roth IRA conversions cannot be withdrawn (without penalty) until after 5 years have passed since they were converted
- Roth IRA contributions can always be taken out at any time
- The maximum income to contribute to the Roth IRA is $144,000 in 2022, after deductions (including Traditional 401k deductions). This changes every year, so be sure to check if you’re reading this in the far future.
To be more precise, the maximum income limit is based off your modified adjusted gross income.
Based on the income limits, the Roth IRA is generally not geared towards the wealthy.
Traditional IRA
The Traditional IRA is quite versatile, providing a tax-shelter for all kinds of earners. It can be funded with both pre-tax and post-tax dollars (keeping in mind some income restrictions on the pre-tax contributions).
If funded with pre-tax dollars, income tax is paid upon withdrawal. If funded with post-tax dollars, income tax is only paid upon the earnings.
The complexity of the traditional IRA arises when you have both pre-tax and post-tax dollars in the account, as you must keep track of what proportion of each you have made. The post-tax principal can be withdrawn tax free, but the post-tax gains and all of the pre-tax portion requires income tax to be paid. Withdrawals must be made in equal proportion to pre-tax and post-tax contributions.
Personally, the complexity of all of this just makes the Roth IRA look perfect.
Post-tax contributions to a Traditional IRA need to be reported to the IRS via Form 8606. If your contributions are not reported, you will lose the ability to shield your post-tax contributions and will be double-taxed on those dollars when you withdraw.
Note: All money in a Traditional IRA is just… money. It is not separated by pre-tax or post-tax dollars. It’s like mixing coffee with the creamer, once it’s in, it’s impossible to separate. That’s why you have to keep track of contributions yourself!
Conversions, Rollovers, (Mega) Backdoors
What’s the point of all of this if finance is just a social construct anyways?
Conversions and Rollovers
The difference between a conversion and a rollover is mostly a technical detail. Conversions happen between any kind of Traditional and Roth account, while rollovers happen between two Roth accounts.
A “rollover” between a Roth IRA and another Roth IRA is simply a transfer. Don’t get too clever now.
There are particular rules for conversions and rollovers, but you’ll probably see these the most:
- Traditional IRA to Roth IRA (backdoor)
- Roth 401k to Roth IRA (rollover)
- After-tax 401k to Roth 401k/IRA (mega backdoor)
But why would anyone want to convert or rollover an account?
The Backdoor
Because of it’s powerful tax advantage in old age and simplicity, the Roth IRA is a tantalizing prospect to many investors and is almost always the superior choice when compared to a post-tax funded Traditional IRA. However, due to the income restrictions, many potential Roth IRA investors might find themselves unable to contribute.
Luckily, the IRS allows conversions between the Traditional IRA (which has no income restriction), and the Roth IRA.
“Backdoor” isn’t an official IRS term, just an informal word that clever investors have created.
If you are eligible to contribute directly to a Roth IRA, please do that instead.
To perform the backdoor process:
- Make a non-deductible Traditional IRA contribution (up to the limit) and report it on Form 8606.
- Immediately convert your Traditional IRA into a Roth IRA
Note that the Roth IRA can only hold post-tax dollars, meaning that any gains in the time between contributing to the Traditional IRA and converting the account needs to have income tax paid upon it. If this is done immediately, gains should be none or minimal.
Warning: If you have any pre-tax money in any IRA you may be subject to the pro-rata rule. This is beyond the scope of this article, but you can read more professional advice elsewhere.
That’s all!
The Mega Backdoor
Despite its name, the mega backdoor bears no resemblance to the backdoor. You can perform either or both maneuvers in the same tax year. The mega backdoor refers to a technique that is used to circumvent the $20,500 Traditional and Roth 401k limits via the After-tax 401k. It is easiest to perform if your employer’s retirement plan administrator allows it.
Again, “mega backdoor” is not an official term. Your plan administrator may refer to it as an “in-plan conversion” or an “in-service distribution”.
You may have noticed that the After-tax 401k is relatively useless when compared to the Roth 401k (in which pre-tax dollars grow tax free) and the Traditional 401k (where you can deduct contributions). The after-tax account is arguably the worst of both worlds in providing zero tax benefits, requiring you to contribute after-tax dollars while still being taxed on any gains.
However, you can use the after-tax account to perform either an in-plan conversion to a Roth 401k, or an in-service distribution to a Roth IRA. Depending on your plan administrator, you may not have a choice. If you do, your choice largely depends on whether you prefer the Roth 401k or Roth IRA. You may convert all of the after-tax account.
If you perform an in-service distribution to a Roth IRA, note that you must wait 5 years (and when you’re 59.5) to be able to withdraw the earnings tax-free!
You may rollover a Roth 401k to the Roth IRA at any time, subject to the 5 year rule(s).
The process looks as follows:
- Make after-tax contributions (if your employer allows) to your After-tax 401k.
- Elect either the in-plan conversion or in-service distribution option.
Similar to the backdoor, you must pay any income tax on gains during the period between your after-tax contributions and when the conversion or distribution happens. Some administrators support daily conversions, which can greatly minimize these tax implications.
All Together Now
I applaud you for being able to stay with me for this long. Unless you scrolled here. I don’t blame you if you did.
Here’s a table I scrounged up for the various accounts:
Note that your Traditional IRA administrator does not distinguish between pre-tax and post-tax dollars, as you must keep track of that yourself. It’s included as separate in the chart for clarity of tax treatment for each dollar.
And here’s a handy little diagram for the various rollovers and conversions that can be performed:
Some Disclaimers
This is not a guide. I’m not telling you what to do or how to do it, but just know that there are some options available to you. I’m not a certified accountant and am not qualified to provide financial advice.
If you’re asking me what I’m doing, I’m maxing my Traditional 401k contributions, while making in-plan conversions to a Roth 401k. At some point I’ll probably rollover the Roth 401k into a Roth IRA. I am not eligible to contribute to a Roth IRA directly and do not make Traditional IRA contributions; however, I might consider doing so at some point. There is no particular reason why I’m not doing it other than I’m lazy.
You’d be a fool to trust anything you read on this blog.
