This Little-Known 401(k) Trick Can Open the Floodgates to Roth IRA Savings

There's a retirement crisis in the U.S., with millions of people having saved very little toward their retirement. For most people, just taking maximum advantage of the ability to make regular contributions to an IRA or a 401(k) plan will go a long way toward helping them meet their long-term financial goals.

But for those who are truly motivated, the annual contribution limits on IRAs can make it frustrating to try to save as much as you want in a tax-favored way. In particular, those who prefer tax-free Roth IRAs over traditional tax-deferred retirement accounts face limits on how much they can contribute each year. A little-known strategy that some have called the "megabackdoor Roth" can dramatically boost how much money you can save in these tax-free retirement accounts -- as long as your employer sets things up favorably for you.

What you can typically contribute to a Roth

Roth IRAs let you set money aside on an after-tax basis. Income and gains within the account are treated as tax-free, even when you make withdrawals during retirement. That makes Roths very appealing to those who expect to save a lot toward retirement, because even after quitting your job, those with large nest eggs often will be in relatively high tax brackets and value the tax savings that Roths offer.

The problem is that Roth contribution limits are low -- $5,500 for those under 50 years old and $6,500 for those 50 or older doesn't give hard-core savers much room to take advantage of Roths. Moreover, some high-income taxpayers aren't allowed to make Roth IRA contributions at all. For these people, options to get more money into a Roth are extremely valuable.

Opening the backdoor

There's a backdoor Roth option that many people have become familiar with. This strategy involves opening a nondeductible traditional IRA and then soon thereafter converting it to a Roth. This allows those who otherwise couldn't contribute to a Roth at all to get at least the $5,500 or $6,500 IRA limit into one.

But the bigger opportunity is more complicated and takes advantage of little-known provisions that govern employer-sponsored retirement plans, like 401(k)s. Most people know that employees are generally allowed to contribute up to certain limits from their own pay each year, with the 2018 limit being $18,500. Employers can then provide additional contributions in the form of profit-sharing or an employer match.

What usually flies under the radar is that some employer-sponsored plans let employees contribute additional amounts on an after-tax basis up to the total permissible contribution amount for both employees and employers. For 2018, that number is $55,000. So for those who don't get any match or profit-sharing from their employer, after-tax contributions could be as much as $36,500.

In order for the strategy to work, your employer's plan must include provisions that allow it to accept after-tax contributions. It also requires that you're allowed to make in-service distributions from the plan, because the next step of the strategy is to roll over the after-tax portion of your 401(k) to a Roth IRA.

The IRS allows taxpayers to separate out pre-tax and after-tax money, funding a Roth with the after-tax part without any tax impact. But unless you expect to leave your job soon, your 401(k) has to allow distributions while you're still employed, or else you won't be able to use the strategy effectively.

Get saving!

There aren't that many people who are able to put this much money aside for retirement. Only about 12% of 401(k) plan participants even contribute the $18,500 maximum, and it would take nearly triple that amount to take full advantage of the megabackdoor Roth.

Nevertheless, for those who have the financial capacity to truly max out their retirement savings, this often-overlooked strategy can be a big boon. If your 401(k) plan at work allows after-tax contributions and in-service distributions, take a closer look to see if you can take advantage of this strategy to boost your tax-free retirement nest egg.

The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.