What do my dog (Sherlock) and hamster (Snuffles) have to do with Mega Backdoor Roth 401(k) contributions?
Other than being super cute, these intelligent creatures are masters at squirreling away their treats for later. Sherlock will dig holes (grrr) to save bones for some unknown future event. Snuffles eats only what she needs and hides the rest of her favorite seeds in her cage. Even though I am sure they would both enjoy that bone or those seeds now, they are smart enough to know it may be better for them to squirrel it away to have in the future. So how is this like taking advantage of making Mega Backdoor Roth 401(k) contributions?
You are squirreling away after-tax dollars to use for the future – you are giving up the use of those funds now to use in the future and did I mention, they will grow tax free and will be distributed tax-free! That is better than an old dog-bone for sure (sorry Sherlock).
Imagine that you are 45 years old and earn a $250k salary from your employer. You contribute 8% a year on a pre-tax basis to take advantage maximum employee effective deferral of $19,500. You also receive your company match of 4.5% or $11,250 per year. The total employee + employer contributions for year = $30,750.
But did you know the maximum employer and employee contribution limit for 2021 is $58,000? You thought you were done at the $30,750 but if your cash flow and 401(k)plan allows, you may be able to contribute another $27,250 of after-tax monies to your 401(k). Even better, your 401(k) plan may allow you to withdraw the after-tax piece each year and roll the basis ($27,250 in this case) to a Roth IRA and any earnings would go to a traditional IRA.
To continue with the example above, you continue your 8% pre-tax 401(k) contribution, receive the 4.5% company match, and you elect to contribute 11% to your after-tax 401(k). In January of 2022, the $27,250 has grown to $30,000. You roll the basis ($27,250) to a Roth IRA and the earnings of $2,750 to a traditional IRA. Even if your income level was such that you could contribute directly to a Roth (phased out at $206k for a married filing joint taxpayers), you would be limited to an annual $6k contribution as opposed to the $27,250 in this example. The downside to squirreling away these additional post-tax dollars is that you will not have use of them today.
The chart below shows if you invest $27,250 each year for 10 years and earn 5%, you would end up with over $350,000.
That $350,000 can be withdrawn income tax-free or left to continue to grow and passed on to your heirs income tax-free. In another 40 years with no additional contributions and a 5% rate of return, the Roth IRA would be worth $2,575,446! Be as smart as Sherlock and Snuffles and squirrel those pennies away now for use in the future.
Your ability to do this is dependent on your particular situation and your company’s 401(k)/retirement plan. If you have questions on your ability to take advantage of this scenario through your company’s 401(k), reach out to any of RegentAtlantic’s wealth advisors. Any decision on how much to defer to your 401(k) and whether on a pre-tax, after-tax or Roth basis should be carefully considered with your financial advisor and tax preparer.
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