Are You Maxed Out?

February 24, 2020

When discussing retirement plan contributions recently, a younger client boasted, “I’m maxing out my 401(k)!” What the client meant was that he was contributing enough to receive the full matching contribution from his employer. He was not however contributing the full annual deferral maximum, which is $19,500 this year for those under age 50, and $26,000 for those age 50 and over. Deferral limits have increased for 2020, as they often do, so a review of existing 401(k) contribution elections is a good exercise to perform annually.

401(k) plans can have some odd quirks. While the $19,500 and $26,000 amounts are the contribution limits for most, there are exceptions. A lucky few will have 401(k) plans that allow additional contributions well above those levels. Generally, the key to accessing these higher contribution limits is to make “after-tax contributions” to the 401(k) plan, if allowed. Through a combination of the “normal” limits, employer contributions, and after-tax contributions, those with accommodating 401(k) plans can make combined contributions of up to $57,000 per year (or $63,500 if over 50)!

Of course, there are some catches. Unlike the typical pre-tax contributions that can reduce taxable income, after-tax contributions do not lower present year tax liability. They differ from fully post-tax Roth contributions (which do not reduce current year taxable income but grow, and can be withdrawn, tax free) in that the growth on these after-tax contributions becomes taxable. As a result, after-tax contributions are primarily advantageous when the 401(k) provides a path to shift the after-tax contributions to Roth before they grow over the long term. With tax rates scheduled to revert higher in 2026, those expecting a more stringent tax regime in the future may find this technique of interest.

The conversion of after tax contributions to Roth within a 401(k) has come to be known as the “Mega Backdoor Roth IRA”. Getting after-tax contributions to Roth can be done through in-plan Roth rollovers, or via rollover of the after-tax contributions to a Roth IRA, provided the plan permits “in-service distributions” or “non-hardship withdrawals.” Please note that the conversion may trigger taxes on any existing growth of the after-tax portion. Because of the potential tax consequences, it is worth consulting a tax professional before attempting the maneuver.

Even 401(k) “maximizers” committed to reaching simply normal contribution limits may face hidden challenges. As some 401(k) plans provide a per-pay period employer match, the right approach is to set contribution rates to ensure the employer match is earned in all pay periods, rather than adopting a higher contribution rate which maxes out in less than the full year. Some plans have a more straightforward “true-up” of employer matching regardless of when an employee contributes.

Is there ever a situation where a 401(k) saver should not “max out?” The answer may be “yes” for some. For example, if an individual has higher levels of debt, or if the employer retirement plan available features weaker investment choices with suspect return track records, or higher expense ratios. In all cases decisions on 401(k) contributions should be considered very carefully especially by those with limited incremental funds for investing.

Cameron Simonds