A lot of people who are saving for retirement prefer to use Roth IRAs as part of their retirement plan. This after-tax income can go a long way in retirement, but annual contribution limits can place a constraint on how much money can be saved. Fortunately, there are “back door” options for funding a Roth IRA that get around the contribution limits and allow the account to grow more quickly. One of the fastest growing back door options is using the funds in an employer-sponsored 401(k).
401(k) to Roth IRA Strategies
An employer-sponsored 401(k) account is mainly used to defer the traditional pre-tax contribution limit. For 2015, the limit is $18,000 or $24,000 for employees over the age of fifty years old. However, some 401(k) account holders have started to use the after-tax contribution limit as a way to contribute to a Roth IRA. This system works because the after-tax limit for a 401(k) allows the client to defer money than the pre-tax limit, which for 2015 is a total of $53,000.
The IRS has also made it easier for employees to fund a Roth IRA with funds from a 401(k) by treating the 401(k) distribution as a single distribution, despite having both pre-tax and after-tax contributions mixed together. This rule even applies if the 401(k) distribution will be rolled into different accounts so long as the 401(k) distribution is made all at once.
Employees that can contribute more than the pre-tax contribution and can also give after-tax contributions can then “overfund” a Roth IRA at a later time. The after-tax contributions can be separated and rolled into a Roth IRA when the employee exits the employer-sponsored plan without any tax liability. However, in order to roll the entire 401(k) into a Roth IRA you must move the entire 401(k) balance into a new account.
There are a couple of issues with using a 401(k) to fund a Roth IRA that you should be cognizant of. First, making an after-tax contribution to a 401(k) is different than making a normal contribution to a Roth IRA. For a Roth IRA, contributions are limited to a pre-tax amount, and earnings in that account grow tax-free whereas after-tax contributions are only made tax-deferred.
In addition, earnings on after-tax contributions do not begin to generate tax-free growth until they are rolled into the Roth IRA. However, by making these types of contributions, you can indirectly fund a Roth IRA more than what you could through the maximum contribution limits for that type of account.
Finally, you should check to see whether your employer allows for back-door funding of Roth IRAs through a 401(k). Some employer plans do not allow after-tax contributions so it is important to check before you start making transfer plans for the two types of accounts. However, if it is allowed, over funding a Roth IRA through a 401(k) can be a great, tax-free way to fund your lifestyle after retirement.