IRA Critical Mistake #1

You’ve been very careful with your 401k and IRA. You thought you did everything right.  But ask yourself two questions:  

1. Are you making after-tax contributions to your 401k each year above the IRS pre-tax contribution limit?
   
   
2. Are you automatically converting these contributions to your Roth 401k plan?
   
   

If you answered NO to either question, you may be making IRA Critical Mistake #1 in THE IRA CRITICAL MISTAKES series.

How so? Read on!

IRA Critical Mistake #1 is failing to consider taking two actions:

1. Making contributions to your 401k above the annual IRS pre-tax limit by making “after-tax” contributions
   
   
2. Converting these after-tax contributions to a Roth 401k through what is known as an “automatic daily 401k In-Plan Roth Conversion”
   
   

To be clear, IRA Critical Mistake #1 discusses a strategy for FUTURE 401k after-tax contributions—in other words, for contributions you haven’t yet made. For strategies involving 401k after-tax contributions you have already made, see IRA Critical Mistake #2.

What happens if you make IRA Critical Mistake #1? What do you risk losing?

Let’s look at two of the biggest consequences of making IRA Critical Mistake #1.

The first consequence of making IRA Critical Mistake #1 is to miss the opportunity to stuff far more into your 401k each year by limiting your contributions to the annual IRS pre-tax contribution limit. Every year the IRS limits the pre-tax contributions you can make to your 401k. For 2025, the limit is $23,500 for those under 50, $31,000 for those ages 50-59 and 64 or older, and $34,750 for those ages 60-63.

Many are unaware, however, that the tax code allows additional after-tax contributions once the annual IRS pre-tax contribution limit has been met.

How much more?

In 2025, the limit for employee pre-tax contributions, employee after-tax contributions, and any employer contribution is $70,000 for those under 50, $77,500 for those ages 50-59 and 64 or older, and $81,250 for those ages 60-63.

That’s right, this particular IRS limit includes both your contribution and the contribution from your employer. So, in 2025, subtract your employer’s contribution from $46,500. This difference will give you the maximum 401k after-tax contribution amount you can make this year.

That is a lot of extra retirement savings flowing into a potentially tax-free growth environment. And that is what “hyper-funding” your 401k is all about!

The second consequence of making IRA Critical Mistake #1 is having to pay income tax someday on a portion of your 401k that otherwise could have grown and potentially become tax-free upon withdrawal.

Many 401k plans today offer a Roth 401k option as well as 401k In-Plan Roth conversions. For plans that do, 401k after-tax contributions can be converted to the Roth balance in your 401k while you are still working. This means the earnings on your after-tax contributions can potentially be tax-free rather than being taxable upon withdrawal!

A case study will reveal the tax problem created when 401k after-tax contributions are not converted to a Roth 401k.

• Over the years your 401k after-tax contributions total $100,000, none of which has been converted to a Roth 401k
  
  
• $200,000 of earnings are generated from the $100,000 after-tax contributions
  
  
• 37% income tax bracket at the time of withdrawal
  
  
• After age 59 ½ you withdraw the $100,000 of after-tax contributions along with the $200,000 of earnings
  
  

The withdrawal of the $100,000 of after-tax contributions will be tax-free. The withdrawal of $200,000 of earnings, however, will be fully taxable, triggering income taxes of 37% of $200,0000, or $74,000.

That’s a lot of tax. And that’s a problem. 

Consider these steps to make 401k after-tax contributions above the annual IRS pre-tax limit, and to potentially avoid paying the income tax you’ll someday owe on future earnings generated from your after-tax contributions:

1. Increase your 401k contribution percentage so that contributions exceeding the annual IRS pre-tax limit ($23,500 for under 50, $31,000 for ages 50-59 and 64+, or $34,750 for ages 60-63) will be made on an after-tax basis.  Increase your 401k contribution as high as your budget will allow.  Subtracting your employer’s 401k contribution from $46,500 will give you the maximum 401k after-tax contribution you may make in 2025.
   
   
2. Elect “daily automatic 401k In-Plan Roth Conversions” for all future after-tax 401k contributions.  Automatic daily conversions can reduce or eliminate the tax triggered on each conversion because it reduces the time the contribution can generate taxable earnings.
   
   
3. Successfully implementing this strategy can be complex.  Because of the possibility of triggering unnecessary or unexpected taxes, consult with your financial or tax advisor from the beginning of the planning phase through execution. 

1. If you already have an existing 401k after-tax contribution balance, before electing daily automatic In-Plan Roth conversions, if your plan allows, you might first wish to transfer your after-tax contributions to an outside Roth IRA and transfer the earnings from the after-tax contributions to an outside Traditional IRA.  Doing this first may reduce or eliminate the income tax when future 401k after-tax contributions are automatically converted to your Roth 401k.
   
   
2. If your 401k allows In-Plan Roth conversations but does not offer the “daily automatic” feature, you will likely trigger income taxation when you later manually convert 401k after-tax contributions to your Roth 401k. Because of this potential taxation, if the “daily automatic” feature is not available, you might altogether skip converting 401k after-tax contributions to your Roth 401k.  Instead, if your 401k plan allows, you might implement an alternative strategy of periodically transferring your 401k after-tax contributions to an outside Roth IRA, and transferring the earnings from your after-tax contributions to a Traditional IRA.  To learn about this important strategy
   
   Click Here to access IRA Critical Mistake #2: Not Considering Transferring Existing 401k After-Tax Contributions to a Roth IRA

• Making 401k after-tax contributions above the annual IRS pre-tax limit ($23,500 for under 50, $31,000 for ages 50-59 and 64+, or $34,750 for ages 60-63), , then converting them to your Roth 401k, effectively allows you to stuff far more into your Roth 401k than the annual Roth IRA contribution limit set each year by the IRS.
  
  
• When you convert 401k after-tax contributions to your Roth 401k, all growth of these contributions now takes place inside the Roth 401k.  This means all growth in the Roth 401k may potentially be withdrawn tax-free, assuming IRS rules are followed for tax-free distributions from Roth 401k’s.
  
  
• Move quickly.  The sooner you convert future 401k after-tax contributions to your Roth 401k, the sooner your 401k after-tax contributions may grow tax-fee!

• With your financial or tax advisor, review your 401k plan document or contact your 401k provider to determine if you are a candidate for this strategy by finding out
  
  
  • If 401k contributions exceeding the annual IRS pre-tax contribution limit are allowed
  • If 401k In-Plan Roth conversions are allowed
  • If “daily automatic” 401k In-Plan Roth conversions are allowed
    
    
• A 401k In-Plan Roth conversion may increase your tax liability in the year of conversion. Before acting, consult with your financial or tax advisor to determine the impact on your personal tax situation.
  
  
• Implementing these strategies on may affect your eligibility to implement another tax strategy worthy of consideration called “Net Unrealized Appreciation.”  To learn more 
  
  
  • Click Here to access IRA Critical Mistake #3:  Have Employer Stock in 401k? Do This Before Rollover to IRA