5 Hidden Features Of Your 401(k) Plan
Strap on your scuba gear and go under the surface of your 401(k) plan. It’s not as beautiful as the Great Barrier Reef, but there may be some money & tax benefits for you here.
If you’re not familiar with your 401(k) plan, it’s what many US companies offer us in place of the pensions that your grandparents probably had. I encourage my clients to think of it just like any other account that has value—like a bank account, a trust, an investment account, or a piece of real estate. It’s an asset that can only be owned individually, and it’s part of a “plan” sponsored by your employer.
And the self-employed won’t be left out of this discussion either, as they are allowed to directly set up 401(k)s sponsored by themselves!
So without further ado, let’s dive into each of the 5 hidden features of your 401(k): 🤿
- Feature 1: Roth 401(k) deferral
- Feature 2: Self-directed accounts
- Feature 3: Rule of 55
- Feature 4: Roth conversions
- Feature 5: Mega backdoor Roth
Roth 401(k) deferral
Back in 1998, Senator William Roth came up with the “Roth” arrangement, allowing people to invest their taxable income so that it can grow and be withdrawn tax-free in retirement. And the arrangement was so fruitful that they limited the Roth individual retirement account (IRA) version to a cap of just $2,000 per year.
Roth accounts grow tax-free, but earners must pay income tax on whatever amount that goes into the Roth account. The Roth IRA limit has grown from $2,000 in 1998 to $6,000 in 2022, but arguably more interesting is the Roth 401(k) which has a contribution limit of $20,500 today.
Whether you contribute to a Roth or a Traditional 401(k) is a tradeoff—there are no magic answers as to which is better for you. I will tell you that if you are on the fence though, I like to use 2 key variables to make the decision: tax bracket + age.
- If you’re younger, Roth accounts are even more valuable, because the tax-free compounding can continue for really long periods of time.
- If your tax bracket is lower rather than higher (e.g. 12% vs. 32%), then the Roth 401(k) could be a fantastic deal compared to a Traditional 401(k) deferral.
This feature usually isn’t “hidden,” but often misunderstood and under-appreciated by employees who may not even know this feature exists in their plan. And it doesn’t exist in every plan, so be sure to check that your planner offers this Roth deferral option.
401(k)s are, by nature, rigid structures. And there are good reasons for this. We all need to follow the rules strictly to ensure that those benefits allowed by law are, ultimately, available and beneficial to employees.
My favorite metaphor here is that investing in your 401(k) is like going to the bowling alley and using the bumpers. Bumpers keep you from throwing a truly terrible shot; they aren’t going to make you throw a strike, but you won’t be far off.
This is why you’re often going to see a fund lineup of diversified portfolios of stocks and bonds inside your 401(k) investment menu. They don’t want you to throw your investment bowling ball into the ceiling or the gutter. And, for the most part, this works! People earn better returns in their 401(k)s by choosing sleepy, diversified investments and letting them set.
But, I’m here to upset that apple cart by letting you know that in many cases, you can also take down those bumpers. And that feature is called a self-directed account. This will let you own brokerage assets (e.g. stocks, bonds, funds—anything you can get on your average investment platform) inside of a special subaccount in your 401(k).
- The upside: You can stop complaining about your limited fund lineup and choose from a much larger universe of investments for your account.
- The downside: You might trade your way to a zero balance if you’re constantly trading in search of the next big tech stock. You also lose the “automation” feature of using the fund lineups, where your plan automatically rebalances your contributions into the portfolio of choice each pay period.
Rule of 55
Hardly anyone knows about this one. I’ve discussed it with other financial planners who aren’t even familiar with it.
Here’s the deal: Most of the time, when we are discussing the possibility of withdrawing from your 401(k), we use the age 59.5—the age when you can access your retirement accounts (i.e., Roth IRAs, IRAs, SEP IRAs, 401(k)s, etc.) penalty-free.
However, there’s a wonderful feature of 401(k)s known as the Rule of 55. It says that if you leave your job anytime during or after the year of your 55th birthday, you can access the 401(k) balance from that job’s 401(k) penalty-free.
This is 4.5 extra years of 401(k) withdrawal access that most people never think about.
You can also roll-in old IRAs or 401(k)s from previous employers in order to have this rule apply.
If you’re in your 50s and considering early retirement, this is a fantastic deal. But always be sure to consider the tradeoffs of consolidating your retirement assets into your current employer’s 401(k).
In-Plan Roth Conversions
Roth conversions are not on most people’s minds most days of the week. Heck, sometimes I forget about them when I’m walking my dog or throwing a rock into a pond.
But we need to remember them.
A Roth conversion is one of the most powerful tools in financial planning.
- How is that? For the uninitiated, a Roth conversion is a move in which you take a chunk of money from a traditional retirement account (IRA, 401k, SEP IRA, etc) and purposefully move it into a Roth account. You’ll see this commonly with pre-retirees as a planning strategy to minimize required minimum distributions (RMDs). As you migh have guessed, this is a taxable transaction, which means you will increase your taxable income in the year in which you convert to a Roth.
- Wait, why would anyone do that? Imagine a “down year” in terms of income. Perhaps it’s your first year of retirement or a year you take a sabbatical year inside a long career of high earnings & tax rates. These are the perfect opportunities for Roth conversions because you can move “pre-tax” money over into your “tax-free” Roth bucket.
- But there’s more. And, incredibly, you may even be able to do this all within your 401(k) plan. This feature has become more common over the years with the prevalence of the Mega Backdoor Roth (more to come on that), but on its own, it’s pretty remarkable.
If you’re considering this, you need to have a careful discussion of tax brackets, withholding, and your federal and state income tax situation overall. Yet, despite all that, this is a fantastic feature when markets are down and in those years you make or expect to make a lower income.
Mega Backdoor Roth
The holy grail of fancy 401(k) features, and the most confusingly named, the Mega Backdoor Roth may be the single most valuable feature on this list.
In short, the Mega Backdoor Roth is an opportunity to use your 401(k) above and beyond the salary deferral limits ($20,500 in 2022) and stuff a bunch of money into a tax-free Roth account.
The mechanics are wonky, as are the limits:
Mechanics: make sure your plan has this feature. Defer some of your paycheck into an “After-Tax Non-Roth Account”, which is exactly what you think it is. Immediately, and hopefully automatically, convert that After-Tax Non-Roth balance into a Roth balance and invest it.
Limits: The limits will depend on your employer’s matching scheme. Some plans have adopted specific limits; for example, Coinbase recently set a limit on after-tax contributions of $37,450 per year, which is the correct maximum based on their employer matching scheme.
See the diagram below to start to unpack the tangled web of interconnected “maximums” for 2022. Also, if anyone tells you that they’re “maxing out their 401(k),” ask them which bucket they are referring to. 🪣
Source: Montebello Avenue
Of these 5 features, only one is baked-in to all 401(k) plans: the rule of 55. The rest are optional, meaning that your “plan sponsor” or employer would need to adopt them as part of the plan.
They come with varying levels of commonality and administrative cost, so not all employers will be able to afford them.
And don’t forget to check your plan documents that are tucked away inside your 401(k) login.
About the author, Robinson Crawford, CFP®
⭐ Certified Financial Planner®
⭐ 8+ years of financial planning experience
⭐ Featured in the New York Times, Wall Street Journal, & Barron’s
⭐ BS, Computational Mathematical Sciences - Arizona State University
⭐ Founder of Montebello Avenue; advisor to Finny
"A great advisor prioritizes his clients’ values and aspirations above all else. My job is to listen, understand, and work alongside you to ensure that your money works for you - not the other way around." - Robinson Crawford