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While there is virtually an unlimited number of topics in personal finance to write on, I like to address client questions in my articles. This one relates to something I wrote about 2 years ago (here) and is a good reminder to always double check the rules.
401(k) Contributions Rules
For years people have been able to contribute to 401(k) plans through their employer on a pre-tax basis up to certain limits. For 2018, employees can make pre-tax contributions of $18,500 with a $6,000 catchup contribution if 50 years of age or older. Employers may also contribute to an employee’s account through matching, non-elective, and profit-sharing contributions as well as allocated forfeitures.
In addition, the employee can usually contribute on an after-tax basis until total plan contributions reach $55,000 ($61,000 if 50 or older). This last piece is determined on a plan-by-plan basis. Some employers will allow the additional contributions and some will not, so everyone should check their Summary Plan Description (SPD) or with Human Resources.
Roth 401(k) Contributions Rules
Roth 401(k) plans first started in 2006 but were only initially available for a few years. Naturally, many companies did not provide these plans because the cost of administration is higher for creation of a new plan. These were later made permanent and wide-spread adoption ensued.
The contribution thresholds are the same as that for the traditional 401(k) plans. However, like traditional IRAs and Roth IRAs, the contribution threshold is met by aggregate contributions to each type of plan. In other words, you have one $18,500 threshold, not two.
Example 1: John (age 40) can contribute to his employer’s 401(k) and Roth 401(k) plan. He decides to contribute $15,000 to his regular 401(k). This means that he can only contribute up to $3,500 to the Roth 401(k) so the total aggregate contributions equal $18,500.
The client question centered around these rules. Here’s the idea: contribute $18,500 to the traditional 401(k) plan as pre-tax contributions. At this point she would not be eligible to contribute anything to the Roth 401(k). However, could she make post-tax contributions to the traditional 401(k) and then roll over just the post-tax contributions to the Roth 401(k)?
Short Answer: No.
Long Answer: Can she contribute $18,500 in pre-tax contributions and then additional post-tax contributions to her traditional 401(k)? Yes. The problem she is trying to avoid, however, is the post-tax contributions will generate earnings over time that will eventually be taxable when she takes them out of the 401(k). By moving the post-tax money to the Roth, the earnings would never be taxed (provided she meets all the rules for qualified distributions).
The reason this plan doesn’t work is two-fold.
I love “outside the box” thinking and brainstorming ways to maximize your benefits while minimizing taxes or other costs. However, I warn everyone to check with an expert before making any moves to ensure that you haven’t missed something important. In this client’s case, it would have created a huge taxable income event that was not expected.