With their tax-free growth and tax-free withdrawals, Roth IRAs are a great deal — if you qualify. If you don’t, well, there’s still a way to get into the game in a big way.
While contributions to a Roth IRA are never tax deductible, these accounts grow tax-free and any qualified withdrawals come out tax-free as well — which makes them a great deal.
The problem is if your income is over $139,000 for a single taxpayer (or $206,000 for married filing jointly) you don’t qualify to contribute to a Roth IRA. But there may be another way some high-income earners can still put large amounts into these Roth IRA accounts.
In 2020 anyone, regardless of how much they make, can save up to $19,500 in a regular pretax 401(k) or Roth 401(k) or similar retirement plan, and if you're 50 years of age or older, you can put in an additional $6,500, as a catch-up contribution, for a grand total of $26,000.
If you still have additional funds that you want to save, with a potential tax advantage as a goal, you may want to consider making "after-tax contributions" to your 401(k) if your company plan allows it.
Why? Although there are a several reasons, the most important is it may put you in a position to convert these after-tax funds to a Roth IRA, even if you earn too much money to qualify.
Roth 401(k)s versus After-Tax Contributions to Regular 401(k)s
To better understand how this works, it helps to know the similarities and differences of contributions to a Roth 401(k) and after-tax contributions put into a regular pretax 401(k). In both cases the contributions are made with after-tax money, which means these funds are not sheltered from taxes.
The reason you can put in these additional after-tax funds, is because the IRS allows a total of up to $57,000 to be saved in a 401(k) plan for 2020 ($63,500 for those 50 and older). This includes your initial $19,500 contribution ($26,000 for those 50 and older), any matching or profit sharing made by your employer, and finally your after-tax contributions, until your combined total from these sources gets you up to the $57,000 ($63,500 for those 50 and older).
The silver lining in making these after-tax contributions is that it’s very likely you will be able to roll them over to a Roth IRA, or in some cases to a Roth 401(k). This would then put you in a position where all the future earnings would be tax-free instead of being fully taxable upon withdrawal. In essence turning it into a giant Roth IRA.
An Example to Show How High Earners Can Pump Up Their Roth IRAs
As a simple example, let's say Bill is 60 years old, married filing a joint return with income over $206,000, which means he makes too much money to buy a Roth IRA. Because he’s 60, he qualifies for the $6,500 catch-up, so Bill could make elective deferrals into his retirement plan of up to $26,000, either in a Roth 401(k) or a regular pretax 401(k).
Let’s assume Bill’s company plan does not offer a Roth 401(k), so he puts $26,000 into a regular pretax 401(k) for the year. Now, let's say that Bill's employer, between a company match and profit-sharing, adds another $10,000 on Bill’s behalf, which now gives him a total of $36,000 for the year.
Since the IRS allows up to $63,500 to be saved in a 401(k) for someone 50 or older, this still leaves an additional $27,500 that Bill can put into his 401(k) plan, as after-tax contributions, if his company makes this option available.
This creates an opportunity to make a huge Roth IRA contribution, through the use of an in-service withdrawal, which is allowed by about 70% of company plans. An in-service withdrawal occurs when an employee takes a distribution from a company retirement plan, such as a 401(k), while still working for their company, and in this case, rolls it over to an IRA. This may occur any time after the employee reaches age 59½. You can verify if your plan offers such withdrawals by requesting a copy of the summary plan description.
Most company plans would allow Bill to do a partial rollover of only his after-tax contributions and any earnings attributed to these contributions. He could roll the after-tax money to a Roth IRA and the pretax earnings to a traditional IRA and avoid creating any taxable income.*
While Bill made too much money to buy a $7,000 Roth IRA, by making after-tax contributions to his 401(k) and then rolling them over, it allowed him to put $27,500 into a Roth IRA. What a deal for Bill.
*If his company plan did not allow in-service withdrawals, Bill could still roll his after-tax contributions over to a Roth IRA after separating from his employer, but this delay would likely create more pretax earnings — which would be taxable upon withdrawal — and less of the more desirable tax-free earnings.