21 Oct How much can we save in a 401(k) plan?

Q. Why do so many advisors incorrectly state that the maximum you can contribute to a 401(k) is $19,000 plus a $6,000 catch-up contribution for those over age 50. This is blatantly wrong. You can actually save far more and then put the money in a Roth IRA. Why does no one talk about that?
— Investor

A. You’re correct that many employees can save more in their 401(k), but not all contributions are created equal.

As you said, the maximum pre-tax 401(k) contribution for an individual is $19,000, plus an additional $6,000 catch-up contribution for participants over age 50, said Ken Van Leeuwen, a certified financial planner with Van Leeuwen & Company in Princeton.

The key phrase here is “pre-tax.”

“The IRS allows total maximum contributions of the lesser of 100% of compensation or $56,000 to plans maintained by one employer in 2019,” Van Leeuwen said. “This means that participants under 50 can contribute an additional $26,000, while those over 50 can contribute $32,000 in after-tax dollars.”

But, he said, it’s important to understand that not all employer-sponsored retirement plans allow after-tax contributions.

Van Leeuwen said if your plan does offer it, there are several factors to consider before deciding to make after-tax contributions.

“Before you consider taking full advantage of after-tax contributions, you should be sure that you have sufficient assets held outside of retirement savings to provide short-term liquidity and funding for medium-term goals,” he said. “You should also be sure to take advantage of tax-deferred contributions in your traditional IRA before making after-tax contributions.”

Once these priorities are met, only then should you consider after-tax contributions, he said.

Because these contributions are not tax deductible, the main benefit would be the tax-deferred growth, he said. After-tax contributions grow tax-deferred in the same way that pre-tax contributions do, so that’s a benefit even though after-tax contributions are not tax deductible.

This could allow you to grow your retirement assets at a quicker pace as you earn interest on a larger base of assets, he said.

If your goal is to eventually roll these funds into a Roth IRA to take advantage of tax-free growth, you will need to consider some other limitations.

“Most plans will not allow you to roll funds, either pre-tax or after tax into a self-directed retirement plan such as a traditional or Roth IRA until you separate from service with the employer,” Van Leeuwen said.

You should also understand the tax implications of rolling these funds into a Roth IRA.

When you are eligible to roll your funds out of the 401(k), all of your after-tax contributions can be rolled into a Roth IRA with no tax implications, he said.

“The earnings on the after-tax contributions, however, can only be rolled into a traditional IRA because these funds have not yet been taxed,” he said. “The earnings from these contributions will be taxed as ordinary income when withdrawn in retirement.”

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This story was originally published on Oct. 21, 2019.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.