Maximize Roth retirement savings through "back door" contributions
Saving money in a Roth 401(k) or Roth IRA is one of the best long-term ways to build tax-free retirement savings. Money invested in Roth accounts grows tax-deferred, and all money -- including investment gains -- is completely tax-free when withdrawn in retirement.
But of course, you'll have to follow the rules that regulate Roths. For instance, how much you can contribute to a Roth IRA each year is limited to $6,000 in 2019, or $7,000 for those age 50 and older. And those with higher incomes ($137,000 for single tax filers and $203,000 for marrieds filing jointly) -- who would benefit the most from a Roth IRA -- can't make Roth contributions.
However, if you want to contribute more than the limits allow and to maximize your Roth retirement savings by thousands of additional dollars, you have some options.
Slip in the "back door"
One way to get around the contribution limits is to take advantage of the "back-door Roth IRA" strategy. You do this by making aftertax contributions to your employer's 401(k) plan and then transferring those contributions to a Roth IRA. Even those with incomes above the limits can do it.
Here's the catch: You must participate in an 401(k) that allows aftertax contributions and allows you to take an "in-service withdrawal" of these aftertax contributions.
Here's how a "back-door Roth" works. The first step is to "top-up" your 401(k) with aftertax contributions. In 2019, the limit for 401(k) contributions is $19,000, or $25,000 for workers age 50 and older, plus an employer match of up to $6,000. A lot of 401(k)s also permit aftertax contributions up to a total IRS maximum of $56,000, or $62,000 for workers age 50 and older. So if in 2019 you contribute $19,000, and your employer match is $6,000, you can make an additional top-up aftertax contribution of $31,000 ($56,000 less the $19,000 and $6,000) or $37,000 for workers age 50 and older.
Take your money and move it
The next step is to immediately take an "in-service withdrawal" of the additional aftertax contributions and transfer it to a Roth IRA. This works best if you do it right after the extra contributions are made so that little or no earnings have accrued on the aftertax contributions. If you take a withdrawal of aftertax money that has grown in the plan, you'll also have to withdraw the earnings attributed to that money.
While the withdrawn earnings can be taxable, you're allowed to roll over the untaxed earnings to a traditional IRA. When you do that, the earnings won't be included in your taxable income until withdrawn from the traditional IRA later. Make sure you open a Roth IRA before you do this. When you do, you'll be ready to deposit the aftertax money into the new account when it's distributed.
Or convert it within your plan
Another way to supersize the money you save in Roth accounts is to take advantage of a special feature in a 401(k) plan. Some employers allow for what's known as a Roth 401(k) in-plan conversions within their 401(k). Similar to the "back-door Roth IRA," participants make aftertax contributions up to the plan's limits. Instead of taking an "in-service withdrawal," the participant elects the in-plan conversion feature, and the contributions are automatically converted to Roth-type contributions.
Some plans, such as Google's, are rolling this out as an automatic feature at year-end. This will allow employees to take advantage of this valuable feature beginning 2019.
Plan carefully and with help
It's important to remember that Roth savings works best as part of a long-term investment strategy. The longer money is invested in a Roth, the more investment gains will be in the account, which will be tax-free when withdrawn many years down the road.
Also, before you proceed, make sure the money you save in Roth type accounts won't be needed for any other purpose than retirement. To benefit from tax-free withdrawals, funds in Roth accounts must have been invested at least five years and withdrawn after age 59½.
Also, Roth accounts aren't subject to the required minimum distribution rules that apply to those over age 70 who own other IRAs and retirement accounts.
Before starting a Roth-maximizing strategy, run it by your tax and financial advisers.