Large savers can increase their retirement reserve with this option

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Lots of people know about their 401 (k) benefits, but their plan may have a hidden feature that delivers even more savings.

When a person reaches their maximum of 401 (k) – $ 19,500 in annual contributions for those under 50 in 2021 – some plans may allow them to put more money into their account.

After-tax 401 (k) contributions can save someone up to $ 58,000 in 2021, including employer matching, profit sharing, and other deposits in the plan.

Later, investors can use a so-called Roth mega-backdoor maneuver, paying withdrawals from after-tax income, to transfer the money to a Roth individual retirement account.

“This can be a really, really powerful technique for the right person,” said certified financial planner Dan Galli, owner of Dan J. Galli & Associates in Norwell, Massachusetts.

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By rolling the money into a Roth IRA, investors can begin to build a tax-free pot of money for retirement, with no rules for withdrawing the money at a certain age.

“If they’re young enough and have years of tax-free growth ahead of them, that could be a game-changer,” said JoAnn May, CFP and CPA at Forest Asset Management in Berwyn, Illinois.

After-tax contributions vs Roth 401 (k)

It’s easy to confuse 401 (k) after-tax contributions with a Roth 401 (k) account because both save employees money after-tax, but there are significant differences.

For example, employees under the age of 50 can carry up to $ 19,500 of their salary into their company’s regular 401 (k) pre-tax or Roth (after-tax) account.

However, you can make additional after-tax contributions to your traditional 401 (k), saving you more than the $ 19,500 cap.

For example, if someone defers $ 19,500 and their employer deposits $ 8,000 for matches and profit sharing, they may save an additional $ 30,500 before they reach the plan limit of $ 58,000.

If they’re young enough and have years of tax-free growth ahead of them, that could be a game-changer.

JoAnn May

Financial Planner at Forest Asset Management

The other twist is how income is taxed. Although Roth 401 (k) withdrawals (including income growth) are tax exempt in retirement, all income on these “bonus” amounts is taxed. Yes, it is confusing.

“This is why it is important to obtain [after-tax contributions] of the 401 (k) plan periodically, ”said May.

Once a year, its clients withdraw their contributions and after-tax income and transfer the money to a pre-tax or Roth IRA. The downside to the Roth IRA option is that there may be a growth tax bill on the conversion.

Keep in mind that the feature is not available for all plans.

While many 401 (k) offer Roth accounts, after-tax contributions are less common. Less than 20% of 401 (k) plans provided after-tax contributions in 2019, Vanguard reported.

Additionally, plans with 401 (k) after-tax contributions may not notify employees of this option. In some cases, advisors may discover functionality buried deep in a client’s benefits documents.

“The most important thing is to read your benefits manual and pass it on to your advisor,” May said.

Taxable retirement income

Whether someone takes advantage of after-tax or Roth contributions, tax-free money can be invaluable in retirement, Galli said.

When clients apply for Social Security, income from their wallet can interfere with these benefits. Retirees can pay income taxes up to 50% to 85% of their Social Security payments, depending on their modified adjusted gross income.

About 40% of those who receive income from Social Security pay taxes on their benefits, according to the Social security administration.

Some retirees may also pay more for health insurance premiums. While most retirees do not pay for Medicare Part A, the base price for Health insurance part B starts at $ 148.50 for 2021.

Depending on their income, retirees may have to pay more for Medicare Part B, with higher incomes paying monthly premiums of $ 504.90.

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