401(k)
2023-04-24What are 401(k)s?
A 401(k) plan is a qualified retirement savings plan that allows individuals to permit their employers to deduct a certain percentage of each paycheck directly to the savings account. The employers may choose to match a certain amount of contribution to the 401(k).
In the article below, I will give an overview of how to manage the contribution of the 401(k) plans. For more details, please visit the IRS Website.
The 401(k) has two types of plans: Traditional and Roth
Traditional Plan
The traditional plan is what is referred to as tax-deferred plan. Any contribution to this plan happens before you are taxed. So, the contributions are deducted from your salary, and the remaining amount is taxed. Hence, you save on taxes right now; however, when you withdraw the money in retirement, it is taxed at the rate during your retirement.
Roth Plan
The Roth 401(k) plan is where the contributions are made after-tax. Since you pay the tax now, the money grows in the account tax-free and the withdrawals in retirement are not taxed.
Contributions to 401(k)
There are 4 ways to contribute to the 401(k):
- Pre-Tax and/or Roth
- Employer/Company Match
- Post-Tax
There are limitations to how much an individual can contribute. The most well-known limit is the pre-tax contribution limit of $22,500 (in 2023). One of the biggest thing to note is that the limit of $22,500 is applied to both Pre-Tax and Roth contributions, that is, the total contributions of Pre-Tax plus Roth 401(k) should not exceed $22,500. Therefore, I am going to disregard Roth 401(k) contribution right now, and just focus on Post-tax contribution. In the next section I will show how we can go from Post-Tax to Roth 401(k) with the Backdoor Roth strategy.
Therefore, for intents and purposes, we will assume that we have 3 ways to contribute:
- Pre-Tax
- Employer/Company Match
- Post-Tax
As mentioned before, you may already be aware of the well-known pre-tax (or Roth) contribution limit of $22,500. However, there is another not-so-wel-known limit: $66,000 (in 2023). The $66,000 limit is the maximum contribution you can have in your 401(k) when all the 3 ways of contribution are combined. We will use the diagram below to illustrate the different types of contributions and their limits.
For example, in 2023, the maximum individual pre-tax contribution is $22,500, and you decide to max out your 401k. So out of the possible $66,000 you have contributed $22,500, and still have $43,500 available to contribute. Not all employers have a 401k matching program, or will match up to 6% of your individual pre-tax contribution. Microsoft, for instance, has one of the most generous matching programs I have seen. Microsoft matches 50% of your pre-tax contributions. Therefore, in this example, since you contributed $22,500, Microsoft will contribute $11,250 to your 401(k). There is no upper limit to how much an employer can contribute other than to make sure it does not go over the absolute limit of $66,000. So, with your pre-tax contribution and Microsoft's match, your 401(k) has $33,750 in contributions. That leaves, $32,250 that can still be contributed as after-tax contributions
The Backdoor
During the pandemic, the "Backdoor Roth" strategy gained a lot of popularity. Notice how I mainly used post-tax or after-tax contributions so far; well, there is a reason for that. Post-tax or After-tax contribution does not necessarily mean it is a Roth contribution. As a side note, the backdoor roth strategy works for both IRA (Individual Retirement Accounts, covered in a different article) and 401(k) plans. One big caveat to this strategy is the "In-Plan Roth Conversion" feature in your employer's 401(k) plans. Most of the employers today have that option, so it is more commonplace, but confirm with your employer's plan provider that the option is available for your plan. We will continue with the example above, and use the diagram below to understand how the backdoor strategy works.
To recap the example above, there are 3 types of contributions that we made to our 401(k) plan:
- Individual pre-tax: $22,500
- Employer Match: $11,250
- Individual post-tax (or after-tax): $32,250
The diagram below shows how your post-tax contribution ends up being a Roth contribution:
Alright, let's go through the different terms one-by-one, and then we will have another diagram to compare the different types of post-tax accounts:
- Our starting point is the Post-tax / After-tax contribution. To get the maximum benefit of the 401(k) plans, it is better to do a post-tax contribution rather than Roth 401(k) contribution directly
- In-Plan Roth Conversion: This is a feature in your retirement plan that will convert your post-tax contribution to Roth 401(k).
- Rollover: Although this is optional, I would highly recommend converting your Roth 401(k) to a Roth IRA by rolling over your account. If you have switched jobs, you will be familiar with the concept of account roll-overs, as generally, you usually roll over the 401(k) account either to an IRA or to the new employer's 401(k) plan (although it may not be required if your previous employer is ok with you continuing to keep 401k plan open). There are fees associated with the account rollover, so I would suggest doing it quarterly, semi-annually, or annually.
You may be wondering why do we need to go through the trouble with all of these conversions. There are 2 main benefits:
- The biggest one is that with the post-tax contribution you have the opportunity to contribute a lot more and hit the absolute maximum in your 401(k) and have the ability to get around the limitation of the direct Roth 401(k) contribution. Hence, the name "Backdoor Roth."
- The second benefit can be explained by the comparison below:
With Post-Tax, even though the contributions are not taxed on withdrawal, any capital gains (or profit) that you
accummalate on the contribution will be taxed when you withdraw in retirement. However, with Roth 401(k) or
Roth IRA, even the capital gains are not taxed.
On the other hand, Roth IRA provides the benefit of not having to a Required Minimum Distribution (RMD). RMD forces you to start taking withdrawals out of your retirement accounts after a certain age. However, Roth IRA is exempt from that requirement (Keep in mind, though, that after your death the beneficiaries will be forced to start withdrawing funds from it). If you are doing well in retirement, then keeping the money in the Roth IRA for as long as possible will allow you to preserve the wealth and generate generational wealth for your beneficiaries.
In my examples above, I assume that you are maxing out the contributions. However, I realize $66,000 is not always feasible , and so you need to determine how much funds you have available for contribution and how do you want to distribute them. If this year, your tax burden is not going to be high, then contributing more to the Post-Tax might be more beneficial. On the other hand, to reduce the tax burden, contributing to the pre-tax first will be more beneficial (especially since most of the employers will match on your pre-tax or roth contributions but not on the post-tax).
Nevertheless, you can find various resources online to show you the power of compound interest and how your retirement account can grow over time depending on when you start investing (the sooner the better). Below are couple of examples (assuming you will start withdrawing at 60):
Individual Pre-Tax Contribution of $1,800 per-month with no employer match:
| Age | Length of Time (years) | Interest Rate | Ending Balance |
|---|---|---|---|
| 25 | 35 | 6 | $2.4 M |
| 30 | 30 | 6 | $1.7 M |
| 35 | 25 | 6 | $1.1 M |
| 40 | 20 | 6 | $800 K |
Individual Pre-Tax Contribution of $1,910 per-month including 6% employer match:
| Age | Length of Time (years) | Interest Rate | Ending Balance |
|---|---|---|---|
| 25 | 35 | 6 | $2.5 M |
| 30 | 30 | 6 | $1.8 M |
| 35 | 25 | 6 | $1.25 M |
| 40 | 20 | 6 | $843 K |
Individual Pre-Tax Contribution of $2,700 per-month including 50% employer match:
| Age | Length of Time (years) | Interest Rate | Ending Balance |
|---|---|---|---|
| 25 | 35 | 6 | $3.6 M |
| 30 | 30 | 6 | $2.5 M |
| 35 | 25 | 6 | $1.77 M |
| 40 | 20 | 6 | $1.2 M |
Individual Pre-Tax Contribution of $5,500 per-month if you max out the contributions:
| Age | Length of Time (years) | Interest Rate | Ending Balance |
|---|---|---|---|
| 25 | 35 | 6 | $7.3 M |
| 30 | 30 | 6 | $5.2 M |
| 35 | 25 | 6 | $3.6 M |
| 40 | 20 | 6 | $2.4 M |
Conclusion
- To conclude, there are 3 ways to contribute:
- Individual pre-tax
- Employer Match
- Individual post-tax (or after-tax)
- Use all three ways to max out the contribution of $66,000 in your 401(k) plan.
- Use the In-Plan Roth conversion feature for the Backdoor Roth strategy
- [Optional] Convert your Roth 401(k) to Roth IRA
