September 15, 2021
Your 401(k) is an excellent tool that provides you with an enormous opportunity to save for retirement. But like any tool, you only get the maximum benefit if you use it to its full potential.
Are you making the most of yours? Here are five powerful strategies to help bolster your 401k.
1. Max Your Company Match
Let’s start simple—if you’re fortunate to have one, contribute enough to qualify for the entire company match. It’s not a complicated strategy, but it carries immense weight. A company match = free money (so take it)!
This step isn’t difficult for many because, in all likelihood, you’ll want to contribute more than the match. If the match is 100% dollar for dollar up to 6%, that means you need to contribute at least 6% of your salary. While an excellent starting place, you’ll want to work up to about 15-20% of your salary, provided you stay under the annual maximum deferral limit.
2. Add After-Tax Contributions
One of the most overlooked benefits is the ability to make after-tax (distinct from Roth) contributions.
Most people know that 401(k)s have contribution limits—$19,500 with $6,500 in catch-ups for those over 50 in 2021—but what if you could contribute more? According to the IRS, you can. The above limit only applies to your ability to make elective deferrals into tax-deferred or Roth accounts.
Some 401(k) plans also allow after-tax contributions. After-tax contributions aren’t considered deferrals, therefore, aren’t subject to the elective deferral limit.
Instead, the backstop is the annual additions limit of $58,000 ($64,500 if 50 or over), which represents the total from all sources (employee and employer) to your 401k in 2021. You don’t get a tax deduction for after-tax contributions, and you also have to pay taxes on withdrawals of earnings, but you still receive the benefits of tax-deferred growth.
Before you get too excited, understand it is very rare for an employer to offer this due to strict testing requirements on plan benefits. That’s because plans cannot over-benefit the highly compensated employees who would likely be the ones using this strategy.
If you’re one of the fortunate few that are eligible to utilize after-tax contributions to your 401k, understand that pro-rata rules apply to in-plan distributions. That means any distribution from your 401k will be treated as being taken proportionally from each account type.
We’ll illustrate this point with an easy example:
Assume your account balance is $100,000, consisting of $80,000 in pretax amounts and $20,000 in after-tax amounts. You request a distribution of $50,000. Your distribution consists of $40,000 pretax and $10,000 after-tax.
As previously mentioned, earnings associated with after-tax contributions are treated differently than the contributions themselves. They are included as pretax amounts in your account, while the after-tax contributions are separate. That’s helpful because it means you can rollover after-tax contributions to a Roth IRA without including earnings.
Additionally, under Notice 2014-54, you may roll over the pretax amounts in a distribution from your 401k to a traditional IRA without having to include those amounts in your income until they are ultimately distributed from the IRA. Although you will eventually have to pay income tax on those amounts, this strategy allows for continued tax-deferred growth.
3. Consider Both Traditional and Roth 401(k)s
Much of 401k planning centers on managing your taxes, and you should be looking to maximize the value at each tax bracket. Doing so comes down to the tax arbitrage game, where our goal is to minimize your lifetime tax liability.
For starters, see if your plan offers a Roth 401(k).
Of course, the idea is that Roth contributions occur after-tax, but the gains grow tax-free, and distributions remain tax-free in retirement—the opposite of how traditional contributions work. By choosing between the two, you are, in effect, actively picking your preferred tax rate.
In general, when you are in a lower current tax bracket than you anticipate in retirement, contribute to your Roth account. If you find yourself in a higher tax bracket now than you imagine you’ll be in during retirement, contribute to a traditional account.
4. Explore Mega Backdoor Roths
Before adding the “mega” qualifier, let’s first define a backdoor Roth to get started—roll money from a traditional IRA into a Roth IRA.
Why would someone do this? They make too much to contribute to a Roth directly but still want the account’s long-term tax benefits.
Mega (as the name implies) takes the backdoor Roth to the next level. A Mega backdoor Roth takes advantage of the higher 401k contribution limits to make larger rollovers into a Roth IRA.
In 2021, by taking advantage of the 401k annual additions limit, you could contribute an additional $38,500 to a 401k on top of elective deferral limits and roll that into a Roth IRA.
This strategy only works, however, if two conditions exist:
- You have to be able to make after-tax contributions.
- You have a plan that allows a rollover (most plans allow this).
Even if you can complete a mega backdoor Roth, you need to be careful and plan it thoroughly. Remember that after-tax funds are allocated pro-rata to both the funds leaving the account and the funds left behind.
If you want to get all of the 401k plan funds out in the aggregate, you must complete a total conversion. If you do not convert the entire balance of your account, there will be issues converting the total after-tax amount in the future.
5. Look Into A 401(k) Rollover
Despite their many advantages, there are some drawbacks to 401ks. Investment management is often one of them.
You know that your asset allocation is one of the most essential elements of your investment plan. It should reflect your goals and tolerance for market risk. As your investments drift, you need to rebalance to get your portfolio back to its target weight for each investment.
However, many 401ks don’t offer an easy rebalancing solution—something you should do at least annually.
An option to consider, may be to roll your 401k into an IRA while you are still working by using an in-service rollover so that you can gain access to a broader selection of investment choices and have an easier time maintaining the appropriate portfolio weights.
Rollovers work the other way too. If your 401k allows, sometimes it is helpful to roll your IRA into your 401k to avoid IRA aggregation rules and open the opportunity for backdoor Roth conversion.
Which Strategies Are Right For You?
401ks are excellent savings tools that offer much more benefits than simply providing a place to invest and save some tax dollars. If you are proactive with your planning, you can unlock a lot of value with your 401k.
Send us a message or give us a call, and we would be glad to help you see if you can take advantage of any of the strategies mentioned above.