Contribute after-tax dollars to 401k and Traditional IRA?

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Topic Author
canga
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Joined: Thu Nov 26, 2009 7:50 pm

Contribute after-tax dollars to 401k and Traditional IRA?

Post by canga »

Hi,

I signed a 2-year contract for overseas work. I currently max 401k and Roth IRA (25% tax bracket). My income is under the foreign earned income exclusion and the foreign living allowance. I will owe no tax.

I read that one should never contribute after tax dollars to a tax-deferred accounts:

The Quiet Millionaire p. 346:
Never contribute after-tax dollars to an employer-sponsored group tax deferred retirement plan, regular IRA, or insurance company sponsored annuity
Given that I have almost 40 years before I will withdraw 401k money, does it make sense to give up 40 years of tax free compounding and re-balancing? I sent a request to HR to open a Roth 401k, but let's assume that doesn't pull through.

I'm thinking of gradually shifting my current 401k to entirely bonds, contribute the minimum 401k to get the company match, and invest the rest in equity index funds. Does this approach make sense?

Can I also max out a Traditional IRA and roll it over the into a Roth IRA?

Thanks,
canga
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White Coat Investor
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Post by White Coat Investor »

Never isn't right. But you might come out behind a taxable account if you don't have a long horizon and low costs in the tax-deferred accounts. Although the contribution never becomes taxable, all the earnings will be at your full marginal rate, rather than your lower capital gains/dividends rates.

One exception is if you convert the accounts to a Roth soon after making the contribution.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course
xerty24
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Re: Contribute after-tax dollars to 401k and Traditional IRA

Post by xerty24 »

canga wrote:I read that one should never contribute after tax dollars to a tax-deferred accounts:

The Quiet Millionaire p. 346:
Never contribute after-tax dollars to an employer-sponsored group tax deferred retirement plan, regular IRA, or insurance company sponsored annuity
Your source should stay quiet. After-tax contributions can in many circumstances, especially starting next year, get transferred into a Roth IRA - this is very good. In addition, the limit on after-tax contributions to a 401k is much much higher than the Roth IRA, ~$50K less your elective deferrals, which will typically be ~$35K.

You could use after-tax contributions to your 401k (assuming they are allowed) to make your 401k plan into a $50K/year Roth IRA. That's nothing to stay quiet about!

You should know that in order to move the after-tax contributions into a Roth, you'll either need to quit your job (or have various other worse things happen), or have a plan that allows rollovers while employed. After-tax money is allowed to be moved out of the 401k plan while still working under the tax rules (unlike pretax money), although your plan does need to allow this option. Once you roll out the after-tax money into a regular IRA, you can convert that to a Roth (this year if under $100K MAGI) or next in any case. Assuming you had no other IRAs, you would only owe taxes on any gains that happened in the meanwhile for that conversion and then could have a $50K Roth. (If you have other non-Roth IRAs, there are some basis calculations to see if you owe any tax due to converting part of those, but it's basically a fair outcome).
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csoren
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Post by csoren »

Be aware that you cannot fund a Roth IRA when using the FEIE unless you have earned income above the exclusion amount. Keep your 401K contributions up to the max while you're abroad. It's worth asking HR if you can increase your contributions since you cannot fund a Roth.
bb
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Post by bb »

Can't after tax contributions to a 401k make sense
to increase the amount of fixed income that can be held in a
deferred account?

(assumes desired fixed allocation can't
be held in a tax deferred account)
xerty24
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Joined: Tue May 15, 2007 3:43 pm

Post by xerty24 »

bb wrote:Can't after tax contributions to a 401k make sense
to increase the amount of fixed income that can be held in a
deferred account?

(assumes desired fixed allocation can't
be held in a tax deferred account)
Yes. Extra tax-deferred space and/or the opportunity to convert to Roth are both good reasons to consider making after-tax contributions beyond the normal elective deferral limits in your 401k.
Topic Author
canga
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Joined: Thu Nov 26, 2009 7:50 pm

Post by canga »

Thanks for the responses! I think I'll still max the 401k, given that for my generation I'm likely to change jobs in the future. I'll contribute to the Roth 401k if it becomes available.

Two more questions:

Because I'm not contributing to a 401k pre-tax, will I get taxed when I roll the money into a Roth IRA?

Even though I have no taxable income due to foreign earned income exclusion and housing exclusion, is my capital gains taxed at the 25% tax bracket?

Thanks again!
bluto
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Post by bluto »

It is possible to fund the ROTH 401k with the FEIE. After learning about this, I persuaded my employer in Japan to offer a Roth 401k option, which they did. It took the help of financial services company to get it done, but it was well worth it. I was able to contribute 15.5k pre-tax $.

Sorry I can't give a lot of details on the legal issues involved, but we were told that there are loopholes make it possible.
FoolishJumper
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Post by FoolishJumper »

bluto wrote:It is possible to fund the ROTH 401k with the FEIE. After learning about this, I persuaded my employer in Japan to offer a Roth 401k option, which they did. It took the help of financial services company to get it done, but it was well worth it. I was able to contribute 15.5k pre-tax $.

Sorry I can't give a lot of details on the legal issues involved, but we were told that there are loopholes make it possible.
It's actually quite simple. Any W-2 salary can go into a 401(k); the fact that you claim it back for the foreign earned income exclusion has nothing to do with 401(k) regulations. The requirement of non-excluded income only exists for IRAs (as per Pub. 590).

I'll reiterate what csoren said....Canga, you are unable to contribute to a Roth IRA unless you foreign earned income is more than $91,400 and (Modified AGI) less than $116,000. That is a fairly tight window.

Also, as of the most recent change to the Foreign Earned Income (that stupid 'Tax Increase Prevention and Reconciliation Act of 2005' which ruined the loophole which was foreign employment), your tax rates (income, dividend, capital gains, etc.) are dependent upon your income (i.e. not taking away the exclusion). So if you make $100k AGI, prior to 2005 you would be treated by the IRS as making $20k (was $80k FEIE), thereby making you eligible for retirement saver's credit, (possibly) earned income credit, and you'd pay 15% marginal tax rate + 0% capital gains & dividend rate (with the current reduced investment tax rates). These days, the government treats you as if you make $100k AGI to get your rates, so 28% marginal tax rate + 15% capital gains & dividends rate; you then get the taxes back on the first $91,400 of income you paid tax on. In addition, your IRA max income limit is now based on your total income, so the window of eligibility is very tight, as I mentioned above.

That means if you make more than $33,951 (again, ignoring the foreign earned income exclusion), then you are into the 15% gains on LT capital gains and 25% on LT real estate gains (i.e. the rate for your 25% tax bracket as you mentioned).
bluto
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Post by bluto »

FoolishJumper wrote:
bluto wrote:It is possible to fund the ROTH 401k with the FEIE. After learning about this, I persuaded my employer in Japan to offer a Roth 401k option, which they did. It took the help of financial services company to get it done, but it was well worth it. I was able to contribute 15.5k pre-tax $.

Sorry I can't give a lot of details on the legal issues involved, but we were told that there are loopholes make it possible.
It's actually quite simple. Any W-2 salary can go into a 401(k); the fact that you claim it back for the foreign earned income exclusion has nothing to do with 401(k) regulations. The requirement of non-excluded income only exists for IRAs (as per Pub. 590).
Interesting, that is the first I've heard that. The company that helped my employer could not provide a reason other than the lawyers have confirmed it. We always assumed it was a loophole because Roth contributions are after-tax, while we were contributing $s that have never been taxed - which seems to defeat the purpose of the Roth.

Do you know if there is any way to create a personal Roth 401k? I changed employers and no longer have access to any taxed deferred accounts :cry:
Topic Author
canga
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Joined: Thu Nov 26, 2009 7:50 pm

Post by canga »

Thanks FoolishJumper. I knew there'd be strings attached to the foreign earned income exclusion. Losing the IRAw hurts, and the 401k is less appealing. I guess there's only so much you can do to avoid taxes.
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