There is a little-known secret in the tax law that most people and many financial advisors still are not aware of called the Super Roth or Mega Roth. Changes to the law, effective since 2014, allow 401(k) plan participants to really ramp up their Roth 401(k) balances beyond what they can do elsewhere, if done properly.
It is not uncommon for changes to the tax law to take time (even years) to be adopted into 401(k) plans and for them to be discovered later by plan participants. It is always a good idea to call the plan provider to find out what options might be available. You can be a Mega Roth Superhero for your clients!
To take advantage of this strategy, 401(k) participants must first max out their contributions to the plan. After that, they can make after-tax contributions to the plan that are then converted to either the Roth source within the 401(k) plan or a Roth IRA outside of the plan.
Before we get started, remember that when an employer matches an employee’s contribution, it is best to spread that contribution over the full year. The reason is that if the employee maxes out their 401(k) contributions midway through the year, the company will only match their contribution through the time that they were contributing. Employees can lose a lot of potential match by maxing out too early. Call the plan provider if you need help with this. Some plans offer a “true up” match to catch up the employer’s matching contributions when employees contribute too quickly in the year, but not every plan has adopted this.
What is a Super/Mega Roth?
In a normal Roth IRA, investors are limited to annual contributions of $6,000 (or $7,000 at age 50-plus). The Super/Mega Roth allows participants of certain 401(k) plans to put much larger amounts into their 401(k) accounts and then convert those funds into Roth money either inside their plan or as a rollover and conversion into a Roth IRA, depending on the plan rules. Every 401(k) plan has its own rules about how much you can contribute to the plan as a percentage of your pay, whether a Roth source is allowable in the plan, if conversions are allowed to be made, and whether or not you can roll after-tax contributions into a Roth IRA outside of the plan without being penalized.
Who benefits from a Mega/Super Roth?
Not everyone would participate in a Mega/Super Roth, even if they were allowed. The following are profiles of those who would benefit the most:
•. Participants who would like to contribute more than $19,500 (or $26,000 if age 50-plus) to their 401(k) plans.
•. Super-savers looking for additional places to make tax-deferred or tax-free contributions.
•. Participants who earn too much to contribute to a Roth IRA outside of their 401(k) account and have already contributed the maximum pretax to their 401(k) plan. In 2021, a single individual may contribute the full $6,000 ($7,000 if age 50+) to a Roth IRA if their adjusted gross income is below $125,000, but they are phased out at $140,000. For married couples filing joint returns, the full contribution to a Roth IRA is allowed for adjusted gross incomes below $198,000 and they are phased out at $208,000.
What you need to know about 401(k) Plans
Every 401(k) plan is different. Employers (within the limits of the law) may put rules in their plan based on their preferences. For example, some 401(k) plans allow participants to make contributions up to 100% of their income; others may put a limit on such contributions. Some plans allow retirees to continue investing in the plan post retirement; others force retired participants to roll their money out of the plan. Bear in mind that the limit imposed by the IRS on total employer and employee contributions for 2021 is $58,000 (or $64,500 with the catch-up contribution permitted for those age 50-plus).
Let’s look at examples of how this would work:
John Jones, 27, just graduated college, and lives at home with his parents, your clients. He works at ABC Corp. earning $100,000 per year. His 401(k) plan will only allow him to contribute up to 25% of his income to the plan. He has already contributed $6,000 to his Roth IRA plan outside of the 401(k). His 401(k) plan will allow after-tax contributions and will allow him to convert those after-tax contributions to his Roth source within the plan but will not allow him to roll the after-tax funds outside of plan as a conversion to a Roth IRA.
John decides to withhold 25% of his income ($25,000) to max out what he can defer. He puts $19,500 into his pretax source to get a tax deduction. The company does a 7% match of his 401(k), which is an additional $7,000 per year. Because the plan will only allow him to contribute 25%, he contributes an additional $5,500 of after-tax dollars and periodically converts that into the Roth source within the 401(k) plan. If any of the $5,500 grows prior to conversion, he will owe additional tax at ordinary income tax rates on that growth. Here is what that looks like:
$19,500 pretax from John’s paycheck into his 401(k) plan
$7,000 match from ABC Corp.
$5,500 after-tax contribution and conversion to Roth source in 401(k) plan
$32,000 total contributions from employee and employer
+$6,000 contribution into John’s Roth IRA account
$38,000 total contributions between all sources to all retirement accounts
Emilia, Smith, 48, is a super-saver who works for XYZ Corp. XYZ Corporation allows her to contribute up to 100% of her income to the plan. The company matches 50% of the first 10% Emilia contributes, meaning that if Emilia contributes 10%, XYZ will match 5%. She earns $150,000 per year. Her adjusted gross income is well above the federal contribution limit of $76,000 for a single filer to contribute to a Roth IRA. She decides to contribute the following:
$19,500 pretax from Emilia’s paycheck into her 401(k)
$7,500 match from XYZ Corp, (50% of her 10% contribution)
$27,000 total contributions within the plan between employee and employer (well below the IRS contribution limit of $58,000 in 2021).
Emilia could contribute an additional $31,000 ($58,000 – $27,000) into the pretax source, before hitting the total contribution cap, and convert those funds to a Roth source within the plan.
What if I am age 50 or older?
Those age 50 or older are eligible for additional “catch up” contributions.
Helen Green, 55, and Bob Green, 57, work for AAA Corp. Helen has an income of $130,000. Bob has an income of $128,000. Helen and Bob file jointly and they take the standard deduction of $25,100 for 2021. Let’s assume that the AAA Corp.’s plan allows participants to contribute up to 100% of their income and that they have satisfied all of their Highly Compensated Employee (HCE) tests. AAA Corp. matches 100% of their employee’s first 6% of contributions, and Helen and Bob have always contributed 6% to get that match. Recently the kids have moved out and Helen and Bob are ready to ramp up their retirement savings. In the past, they earned too much to be able to make a Roth IRA contribution. Here is what their current contribution schedule looks like to their plans:
$7,800 is Helen’s 6% contribution
$7,800 is AAA Corp’s match at 6%
$7,680 is Bob’s 6% contribution
$7,680 is AAA Corp’s match at 6%
$30,960 is the total contributions among both plans
Note that their current income is as follows:
$130,000 for Helen
$128,000 for Bob
Minus $7,800 for Helen’s 401(k) contribution
Minus $7,680 for Bob’s 401(k) contribution
Equals $242,520 total income
Minus their standard deduction of $25,100 in 2021
Equals $217,420 Adjusted Gross Income (AGI)*
*This AGI is above the 2021 federal phaseout of $208,000 for married couples filing jointly to be able to contribute to a Roth IRA.
As a financial advisor, what can you do to help Helen and Bob minimize taxes and maximize their contributions to all plans?
Helen and Bob are able to max out their pretax contributions to their 401(k) plan. Since they are both over the age of 50, they can each make contributions of $19,500 plus a catch-up contribution of $6,500 in 2021. They can each therefore contribute $26,000 pretax. Remember, the maximum that is allowable between the employer and employee in 2021 is $58,000 for base contributions plus a $6,500 catch-up contribution, for a total of $64,500.
Helen and Bob decide to contribute the maximum to their pretax first, then they want to do the Mega Roth. Here is what that looks like:
$26,000 pretax contribution by Helen
$7,800 contribution by AAA Corp
$33,800 total contributions within the plan between employer and Helen, well below the limit of $64,500
Helen can contribute an additional $30,700 ($64,500-$33,800) into her after tax source and convert that to a Roth source either within the plan, or to a Roth IRA outside of the plan, depending on preference.
Also, Bob may contribute the following:
$26,000 pretax contribution by Bob
$7,680 contribution by AAA Corp
$33,680 total contributions within the plan between employer and Bob, well below the limit of $64,500
Bob can contribute an additional $30,820 ($64,500-$33,680) into his after-tax source and convert that to a Roth source either within the plan, or to a Roth IRA outside of the plan, depending on preference.
This also has a positive tax impact on Helen and Bob because their AGI goes from $217,420 to the following:
$130,000 for Helen
$128,000 for Bob
Minus $26,000 for Helen’s 401(k) contributions
Minus $26,000 for Bob’s 401(k) contributions
Equals $206,000 total income
Minus their standard deduction of $25,100 in 2021
Equals $180,900 Adjusted Gross Income (AGI)
Helen and Bob now qualify for an additional contribution of $7,000 each into their own Roth IRA accounts because they are below the federal limit of $208,000. (The maximum Roth IRA contribution limits are $6,000 for those under age 50 by December 31st of the tax year or $7,000 for those age 50-plus by December 31st of the tax year.)
Once the pretax funds are converted to Roth assets, they grow tax free if distributions are taken out either after five years (called the five-year aging rule) or at/after age 59 ½, whichever comes later.
The first $19,500 (or $26,000 for age 50-plus participants) may be contributed all to a pretax source, all to a Roth source, or to any combination of the two sources.
Remember, every 401(k) plan is different. Some, plans do not allow after-tax contributions, conversion of after-tax funds into a Roth source, or a conversion/rollover of after-tax funds into a Roth IRA. For more information on how to help you clients understand and evaluate their options, check out this flowchart and “Are Mega-Roth Powers Hiding Inside Your Clients’ 401(k) Plans?”
Monica Dwyer, CFP®, CDFA®, is a Certified Financial Planner® Practitioner and Certified Divorce Financial Analyst® with Harvest, Financial Advisors in the Cincinnati/West Chester, Ohio area. She may be reached at firstname.lastname@example.org.