The Roth 401(k) Hidden Contribution

It’s January and people’s thoughts have turned to, what? Football? No. The inauguration? No. 401(k) contributions? Yes!

For 2009, your maximum 401(k) elective deferral is $16,500, and if you are at least age 50 by the end of the year, another $5,500. If you are one of those people (and there are at least 6 or 7 of you out there) who are planning to contribute the maximum, and would contribute more if you were allowed to, you can. Maybe. Sort of.

The way to indirectly increase your 401(k) deferral is to contribute your elective deferral on a Roth basis instead of a traditional pre-tax basis. With a Roth contribution, you get no tax savings up front, but you can arrange for all distributions to be tax-free. And you can also arrange for a future rollover to a Roth IRA where there are no required distributions during your or your spouse’s lifetime. Not at age 70-1/2. Not ever for as long as you live.

The first question you need to ask yourself is whether this avenue is open to you. The bad news is that Roth 401(k) contributions are only available if (a) your employer maintains a 401(k) plan or 403(b) plan, and (b) the plan has been amended to allow Roth contributions. This new type of contribution is sometimes called a “Designated Roth Contribution,” and it’s been available since 2006. The good news is that if your plan offers it, it’s open to you regardless of your income. Roth 401(k)’s differ from Roth IRAs which are only available to people with modest income.

You may not exceed the $16,500 limit by making both pre-tax and Roth 401(k) contributions. You can split your contribution between the two types, but you can’t exceed the $16,500 limit in the aggregate. If that’s the case, then how can you contribute more than $16,500? Read on.

The reason is that by foregoing the tax saving of the traditional pre-tax contribution, you effectively increase the value of your contribution by your tax rate. More accurately, for someone who is in a combined (federal and state) income tax bracket of 30%, the value of a $16,500 Roth 401(k) contribution is roughly equivalent to a pre-tax elective deferral of $23,571. Where did that number come from? It’s equal to $16,500/(1 – 30%). That’s 43% more!

There’s a lot of particulars that will affect how much more a Roth 401(k) contribution is worth to you, but that formula gives you a pretty good rule of thumb. For example, the benefit is reduced if you are in a lower tax bracket after retirement. And the benefit is increased if you have meaningful savings to live on outside of a retirement plan. For a bit more on how and why a Roth contribution is worth more than a pre-tax contribution, see the Position Paper on this subject posted on the Brown Brothers Harriman website.

Bottom line, though, is that if you’ve hit the 401(k) maximum, you should think about the Roth deferral as an end-run around the cap.