Tuesday, June 3, 2014

Double your 401K contribution limit

Double your 401K annual contribution to $36K per year

The IRS limits employee 401K contributions to $18K/year. If you work in corporate America, your company likely offers you the ability to contribute to a 401K plan. If you’re already contributing, you’re off to a great start. If you’re maxing out your 401K plan by contributing $18K a year and you’re not sure what to do with the rest of your income, there is now a new way to double your contribution to $36K/year.

401K options available today
In most 401K plans, you have the option to contribute either pre-tax or post-tax (Roth) dollars to a 401K: 
  • Pre-tax means that you pay no taxes today but you receive a tax bill when you withdraw your money years down the road.
  • Post-tax (Roth) means that you pay taxes today and pay no taxes when you withdraw your money in the future, including all of the gains.

Both offer advantages and disadvantages. Either option is better than investing outside of a 401K.

In the past, the IRS limited contributions to $18K/year. Once you reached the limit, you had to figure out where else to invest your income. At Unlimited Net Worth, we like maxing out savings, so why stop at $18K/year and instead double that to $36K/year.

Double your 401K contribution
Once you max your 401K for the year by contributing $18K, you can continue to contribute even more. In fact, you can contribute another $18K on top of the original $18K. Whoa, so how does that work? 

Some companies have recently allowed employees to contribute up to $18K after-tax dollars in addition to the original $18K 401K contribution. With the $18K after tax dollars, you can call your investment company to convert this into post-tax (Roth) dollars.

With the money invested in Roth, you’ll never have to pay taxes on this money again. This effectively allows you to save an additional $18K/year for a total of $36K/year.

My strategy
Over the past few years, I’ve been maxing out my 401K with $18K/year. I invest all this money using the pre-tax option. I have now started contributing another $18K into my after tax 401K. I call my brokerage firm, once every 3-months to convert my after tax dollars into the Roth option.
401K account demonstrating a Roth in-plan conversion
By splitting my money between Roth and pre-tax, I’m hedging my bets between the two options. Depending on my circumstances when I retire, I’ll be able to tap either my Roth or my pre-tax funds, depending on which one is more advantageous.

If you’re really into saving, once you max out on the $36K yearly contribution, you can continue to invest outside of your 401K. You won’t save on taxes, but you’re still better off with the money invested. Happy investing!

As a note, the $36K/year limit only applies to your contributions. Your employer can contribute or match beyond this amount.

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