How to Maximize Roth Savings Through a 401(k) Plan

A "Roth" retirement account is the greatest savings vehicle ever invented, because all investment profits (earnings) in a Roth account are totally income-tax-free (see exceptions at the end of this article). The only problem is, how do you get money into a Roth account without undue tax cost? This month and next month, two case studies will illustrate little-known ways that some workers can maximize their Roth contributions to a 401(k) at a low (or no) tax cost.

Meet the Code's Contribution Limits These contribution stories arise out of the tax code's two sets of limits on contributions to a 401(k) plan. I gratefully acknowledge the assistance of Denise Appleby of Appleby Retirement Consulting for helping me sort out these tricky limits.

The first is the maximum amount of a "salary reduction" contribution that can be made to a cash or deferred arrangement, or CODA, type of plan. 401(k) plans and 403(b) plans are examples of CODA plans--plans under which the employee can elect in advance to have a certain amount of his/her compensation paid into his/her plan account rather than taking it as cash compensation. This limit for 2019 is $19,000 or, if less, 100% of compensation. If the individual is age 50 or older as of the end of the taxable year, a permitted "catch-up contribution" of up to $6,000 changes this limit to $25,000 or, if less, 100% of compensation.

Other limits are imposed by tax code sections 404 and 415(c), which limit a company's contributions to a defined-contribution plan and its tax deduction for such contributions. All CODA plans are also defined-contribution plans. The limit for 2019 is $56,000 or, if less, 100% of the individual's compensation (or, effectively, 25% of compensation for some plans). A catch-up contribution is not counted in applying these limits.

Start With a Typical 401(k) Contribution and Employer Match Mark, 41, works for a big company and is a member of its 401(k) plan. His pay (W-2 wages and bonus) is $224,000 for 2019. He has elected the maximum permitted "salary reduction" contribution to the 401(k) plan, which is (for his age) $19,000. Although the company's plan permits the employee to designate his salary reduction contribution as a "Roth contribution" (post-tax), Mark wants to reduce his 2019 income tax bill as much as possible, so he chooses the traditional pretax type of 401(k) contribution, and his $19,000 salary reduction contribution will not be included in his taxable W-2 income for 2019. It is tax-deferred.

Mark's employer matched his salary reduction contribution up to 3% of his compensation, so the employer contributed $6,720 to Mark's plan account, bringing the total pretax contribution to Mark's 401(k) account for 2019 to $25,720.

Add a Voluntary Contribution and a Designated Roth Account The employer does not make any additional contribution to Mark's account for 2019. But Mark himself can make an additional contribution: The company's plan allows "voluntary nondeductible employee contributions" to a separate "employee contribution account" in the plan. Though this contribution is not pretax, the earnings that accrue inside this account will be tax-deferred until they are withdrawn. The maximum Mark can contribute is limited by the "415(c) limit," that is, $56,000, minus the $25,720 that has already been contributed to the plan, for a net of $30,280.

Mark contributes $30,280 of aftertax money to his employee contribution account, then immediately (before the contribution has accrued any earnings) converts that account to a designated Roth account within the plan. He is not paying any extra taxes to make this contribution--it is made with aftertax money (money he has already paid income tax on). The contribution does not cost him anything extra because he has already made the maximum pretax contribution to the plan that he can make. And he is not paying any tax on the conversion, because (assuming this aftertax money is the only money in the employee contribution account), there is no pretax money being converted. Note that the money he has accumulated in his CODA account (the pretax contributions deducted from his salary, and the earnings thereon) is not combined with the employee contribution account for purposes of this Roth conversion.

What is the advantage? Assuming Mark was planning to save and invest this $30,280 anyway, this approach allows him to tuck away his $30,280 of savings in a vehicle (Roth 401(k) account) where all investment returns will be totally income-tax-free.

Why This Idea Doesn't Work for Everybody Are there any drawbacks or limitations? Certainly. For one thing, the plan must not only offer designated Roth accounts (not all plans have these), but it must also allow employee voluntary contributions (not all plans do). And even plans that have both of these features may impose stricter limits on contributions; for example, lower contribution limits may be required for certain highly paid employees, in order for the plan to satisfy IRS nondiscrimination requirements. Also, once money is in a qualified plan, you may not be able to get it out prior to reaching a certain age, terminating service (though some plans permit in-service distributions), or meeting some other plan-defined requirement.

Other Limits to Know About Needless to say, the limits and rules for plan contributions are highly complex. Not all limitations are included here. For example, if the individual has multiple sources of compensation income, participates in multiple retirement plans, and/or has substantial ownership of any employer, additional rules and cross limits may apply. For an overview of such limits, as well as those discussed above, consult the Employer Retirement Plans Comparison Table, published annually by IRA educator Appleby (www.deniseappleby.com).

Finally, as a reminder, Roth earnings are tax-free only if distributed (1) at least five years after the employee first contributed to the designated Roth account and (2) after the employee is over age 59½, disabled, or deceased.

Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The new 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is now available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article may or may not reflect the views of Morningstar.