If you are saving up to the employee limit in your workplace retirement accounts and looking to add more, youâll be glad to hear that employers are making it easier than ever to make extra after-tax contributions directly from your paycheck and get tax-free growth in the future.Â
The maximum most people focus on is the $22,500 that workers can defer into a workplace retirement plan in 2023, with an additional $7,500 catch-up for those 50 and over. But thereâs another IRS limit that matters to high-earners, especially in 2023 because of a $5,000 jump due to inflation. You can now contribute a maximum of $66,000 for both the employer and employee contribution together â $73,500 with the catch-up.Â
That opens a window to make a strategic move with after-tax contributions that you can then immediately use to do a backdoor conversion into a Roth account within your retirement plan.Â
The benefit of making after-tax contributions, generally, is to avoid paying tax on the growth until you withdraw the money in retirement, otherwise, you could just keep the money in your pay and put it in a taxable brokerage account. If you move that money to a Roth account, however, you wonât incur tax on the growth at all. In addition, the Roth account will not be subject to required minimum distributions when you are retired.Â
Say, for instance, youâre 55 years old and you make $200,000. If you contribute your maximum with the catch-up and your employer adds a 6% matching contribution, which would be $12,000, youâre only using up $42,000 of the $73,500 allowed. You could add up to $31,500 in after-tax dollars this year if your employer allows that as a plan feature. Depending on how your administrator works, youâd likely make this election in the same place you choose how much you contribute to your 401(k). Setting up the automatic transfer to a Roth account would likely take a phone call, however.Â
âWe saw a 126% increase in participation from 2021 to 2022,â says Nathan Voris, director of investments, insights and consultant services at Schwab Retirement Plan Services. âPeople are starting to see it, starting to understand it.â
How after-tax Roth conversions work
To make use of this strategy, your employer plan has to offer both the feature to make after-tax contributions and the ability to do in-plan conversions to Roth. About 25% of plans that Vanguard handles offer this combination, and about 4% of participants with access have converted assets, says Maria Bruno, head of U.S. wealth planning research at Vanguard.Â
With both features activated, it makes saving extra money kind of seamless. You get paid and taxes are taken out, then the after-tax dollars you designate as a contribution are moved directly to your retirement account. On the back end, the administrator sweeps the account and moves the money into a Roth âbucketâ before it has a chance to accrue any taxable growth.Â
âAs soon as money is invested, itâs converted, so youâre not triggering tax,â says Bruno. âItâs very attractive, because youâre converting what would be taxable growth to tax-free growth, which is kind of unique. Youâre also creating tax diversification.â
Your retirement account probably contains many such buckets, whether you realize it or not. Some administrators will break down the categories of sources for you to see on your account summary. You might have one for your main traditional 401(k) contribution and one for your employerâs matching contribution, plus perhaps another bucket if your plan offers a Roth 401(k) option.Â
The reason the administrator keeps these separated is that different contributions have different limits, vesting schedules and rules governing how you withdraw.Â
âThatâs a day-to-day function of a record-keeper,â says Voris.Â
When you should consider the option
Your salary is going to be the biggest factor of whether you can make use of this retirement plan feature. After-tax contributions will only come into play if youâve already reached the limit of employee contributions, which only 14% of participants do, according to Vanguard.Â
If you have the ability to save more, then after-tax conversions to Roth are appealing. âIf youâre maxing out and youâre looking to add several thousand dollars, it has a real impact. The story sort of tells itself. This is a pretty darn good way to do it,â says Voris.Â
If youâre not quite at that salary level, but youâre still interested in moving as much money into a Roth account as possible, there are ways you can start doing that now. The easiest way is to just put money directly into a Roth IRA. If you are under the IRS income limitâunder $138,000 for singles, or $218,000 for marrieds for the full amountâyou can contribute $6,500 in 2023, or $7,500 if youâre 50 or older. (Note: You can make IRA contributions for 2022 up until your tax filing deadline, but the limits for 2022 are slightly lower, $6,000 and $7,000 with catch-up.)
If your workplace plan offers a Roth 401(k) optionâwhich some 77% of plans do, according to Vanguardâyou can put in all of your $22,500 or whatever portion you wish. Doing steady contributions like this during your working years will save you from having to think about Roth conversions down the road.Â
But not everyone is interested in paying more in taxes now. Roth 401(k)s lag traditional contributions significantly, with only 15% participation. âBehaviorally people want the tax-deferment right away, itâs immediate gratification,â says Bruno.Â
Thereâs also a level of uncertainty as to whether itâs better for you to pay tax now or pay it later, because people donât know whether they will be in a higher or lower tax bracket in retirement when the money starts coming out. For that matter, the age for required minimum distributions keeps changingâitâs now 73, but will be 75 in 10 years.Â
âItâs tricky in peak earning years. Thereâs some math to be done there, to see if it makes sense to do it,â says Bruno.Â
Got a question about the mechanics of investing, how it fits into your overall financial plan and what strategies can help you make the most out of your money? You can write me at beth.pinsker@marketwatch.com.Â