Secret Life of FI usually diverts readers away from Roth IRA/401Ks. Its upfront taxes, income restrictions, and paltry annual $6500 limit make it a limited investment choice.
However, there is a little known (and simple) Roth hack you can use to contribute 7x the Roth limit ($45,000 a year instead of $6,500). This is different than the typical backdoor Roth IRA. Instead, this hack utilizes 401Ks, it takes only 5 button clicks to execute, and has zero tax penalties, unlike other Mega backdoor Roth possibilities that come with red tape.
This simple, virtual paperwork shuffle can create an astounding $300K in tax free investments in just 5 years. For comparison, normal annual Roth contributions ($6500) creates an unimpressive $43K in tax free investments in 5 years.
Want to take advantage of this opportunity? Read on! This post offers an easy to understand roadmap as well as a step by step how-to-guide. Without further ado, introducing . . . the Secret Life of FI Super Roth hack!
Prerequisites
The following prerequisites are required. Fortunately, if you check the first box, you will more than likely be able to check the second box.
- Employer sponsored After Tax 401K
- In-plan Roth 401K conversion option
What’s an After Tax 401K? In short, similar to Roth, the After Tax 401K requires you to pay taxes upfront, and the investment grows tax free. Its superior to Roth IRA/401Ks however in that it has a much higher contribution limit of $66,000 a year.
The drawback of the After tax 401K is the earnings are taxable on withdrawal. Fortunately, this tax penalty can easily be eliminated if your plan meets the second prerequisite: in-plan conversions to a Roth 401K.
If your 401K plan has both options available, you have the power to supercharge your Roth investments by as much as 7X, growing a tax free income stream for life.
Its a master class in tax avoidance. So much so that in 2022 Congress tried (unsuccessfully) to ban it. You should pay attention if Congress has tried to obliterate this tax shelter and get in on the action while you still can.
How the math works
Before we jump into the step by step, let’s first run through the math on how to max out the Super Roth.
First, you need to understand that the IRS allows everyone under 50 to contribute up to $66,000/yr in their 401K. Included in this total is the normal $22,500 in pretax or Roth 401K.
Less known amongst 401K investors is the remaining $43,500, which can be made up of company match and After Tax 401K contributions. After the match, most investors leave the remaining $30K to $40K in tax free investment opportunity on the table by ignoring the After Tax 401K option.
How to take advantage instead? Here is a hypothetical. Let’s suppose you are in a two income household, and you are the Roth investing spouse making $100K a year, with a company match of 5%.
Here is how much in a single year you can contribute to the After Tax 401K after maxing out the pretax 401K.
If our hypothetical person invests the full $66,000 (and converts After tax to Roth) and also purchases a $6,500 Roth IRA, they are contributing 7x the normal Roth limit in addition to pretax investments.
If repeated for 5 years, with a 10% historical average return, here is how much retirement income, mostly tax free, is generated.
Impressive, right? It gets better. If our hypothetical investor never invests another dollar, time in the market alone will make her a millionaire. In 10 years, she’ll have $780K tax free funds and $480K pre tax funds. In 20 years . . . she is a multi-millionaire with $2M in tax free funds and $1M in pre-tax.
This is exactly why Congress considered outlawing After tax to Roth 401K conversions in 2022, and why you should be taking advantage immediately if your plan allows it.
Step by Step Guide
Below, I will lay out the exact steps to execute an After Tax to Roth 401K conversion.
The screenshots and steps I provide will follow conversion on the Alight 401K platform. Your employer may use a different provider, but the steps and principles will be similar.
Step 1. Set up automatic contributions to both Pre Tax and After Tax 401K
It should go without saying: always max out pre-tax 401K first. But you will also need to set up your 401K plan to contribute as well to the after tax 401K. My current setup looks like this:
Step 2. Direct all future 401K contributions to GIC Stable Fund
This is the most important step. GIC stable fund (or similar cash / 0 volatility fund) is critical to ensure your Roth conversion does not inadvertently incur a tax bill because of a wild one day market swing before you can convert it.
Step 3. Convert After Tax to Roth the day of your paycheck deduction
I’m paid twice monthly. Yours might be monthly. Regardless, you will want to do this conversion the day it shows up on your 401K account with every check, all year. This ensures you convert it quickly and eliminate the possibility of being taxed on any gains.
Here are the screens you will click through to convert in Alight. First, click “Convert to Roth.”
Next you will go through a series of screens that make sure you understand the tax implications of an after tax rollover (which will be $0 following this process).
On the next screen, click the blue “Convert to Roth” button.
On the next screen, you will need specify that you are converting After Tax 401K money by inputting 100% in the field next to tax After tax and clicking continue.
The next screen below will estimate taxes owed at $0 (wahoo, we did it right!) and offer you multiple disclosures for further mind numbing reading. Click the blue continue button.
Next, you will be asked to review your After Tax to Roth conversion. Last chance to back ouy . . . nah, you got this. You do want to be tax free forever right? Click continue one final time.
That’s it! You are done. The website will display a message confirming your Roth conversion is complete.
Step 4. One day after you convert, transfer your GIC funds to S&P 500 Index
By now, you’ve successfully converted your After tax 401K to Roth 401K tax free. Its now time to move it out of the low growth GIC Stable fund and into a growth stock fund.
With Alight, your best bet is the low cost S&P 500 index fund called Large US Equity. Your plan will likely have something similar or, better yet, a Total Stock Market Index fund.
Step 5. Rinse and repeat
Repeat this rhythm every check, all year. Its a 2 step process every time, and takes less than 15 seconds. Day 1, convert After Tax to Roth. Day 2, convert GIC to Large US Equity fund. Rinse and repeat. You’ll be swimming in tax free wealth before you know it.
Better act fast
According to Vanguard, only 21% of 401K plans offer the After Tax 401K, though this number has been increasing over the years. If you are part of the 21%, you’re lucky, so take advantage. For everyone else, it never hurts to request your company to expand their offerings.
In the future, Congress may very well put up income limits or seek to ban Roth conversions all together. Fortunately, this is unlikely to change any time soon with our current divided Congress. This gives us at least 2 to 3 years or more of the current rules at minimum, which is still a tremendous opportunity to create a tax free nest egg.
The time to act is now. You can become a multi-millionaire with just 5 years of investing if you max out your employer’s pre and post tax 401Ks and use this ultimate Roth hack. You’ll have a $3M nest egg 20 years later, of which $2M is tax free. Happy trails investors!