By S. Joseph DiSalvo, ChFC and Marie L. Madarasz, AIF
If you are interested in creating and growing a stream of tax-free income in retirement, don’t overlook after-tax contributions in your company’s retirement plan.
For employees who participate in their employer’s 401(k), there may be more impactful options and saving choices available to you beyond investment choices. What we see is that very often, these opportunities are missed because employees are unaware that they exist, or they do not understand the positive impact they may have.
The opportunities we discuss in this article, saving additional money in your plan via after-tax savings, is worth considering because it can both significantly boost your retirement savings as well as allow you to move significant money into a Roth 401(k) or Roth IRA.
What is it? Some 401(k) plans allow employees to save in a few different ways: Pre-tax, Roth contributions or after-tax. To find out what options your plan has, a call to your plan administrator asking what your plan allows is a good place to start.
Let’s define what after-tax contributions are. After-tax contributions are elective deferrals made from already-taxed salary (like Roth contributions, but different as we explain below). You make after-tax contributions to your plan the same way you make pre-tax or Roth contributions. However, unlike earnings on Roth 401(k) contributions, earnings on after-tax contributions are always taxable. But continue reading to see why after-tax contributions are very much worth considering!
What are the dollar limits? There are limits on the amount of elective deferrals (pre-tax and Roth contributions) that a participant can make in a calendar year (for 2021, $19,500, or $26,000 if age 50 or older). However, after-tax contributions do not count against this limit. After-tax contributions, along with all elective deferrals and employer contributions (such as matches), do count against a much higher overall annual limit – for 2021, $58,000 (or $64,500 for over-age-50 employees who defer the additional $6,500). So, an employee who has maxed out on elective deferrals likely will still have enough room to make substantial after-tax contributions.
Example: Janet, age 52, participates in her 401(k) plan that allows after-tax contributions. For 2021, she elects to make pre-tax elective deferrals up to the $26,000 limit. Her employer’s matching contribution is $5,000. If she can afford it, Janet could make up to $33,500 [$64,500 – ($26,000 + $5,000)] in after-tax contributions as well.
Do after-tax contributions have any special rules? How do I know what the impact of making after-tax contributions are for me? Keep reading.
Are After-Tax Contributions the Same as Roth Contributions?
No, absolutely not. Although Roth contributions are made on an after-tax basis, when people talk about “after-tax” money in an employer plan, they are usually talking about funds contributed to the “traditional” side of the plan, but for which no tax break was received. The biggest difference between the two is the tax treatment when distributions are taken in future. While both Roth 401(k) salary deferrals and their earnings can be distributed tax-free (if part of a qualifying distribution), the gains earned on any after-tax contributions to the plan are generally taxable when distributed.
Why Would I Want to Put After-Tax Money into My 401(k)?
Because of these two opportunities:
1). In-Plan Conversions:
If your plan has a Roth component and allows for this, in-plan conversions will let you convert all or some of your savings to the Roth side inside of your plan. If you convert your traditional after-tax savings, you pay taxes today on only the market gains of the after-tax dollars you convert. In the future, you can withdraw any money you convert to the Roth 401(k) tax-free, provided your distribution is considered “qualified.” (Generally, a distribution of Roth savings is considered qualified if you are at least age 59 ½ and your initial Roth contribution was made at least five years prior to the distribution.) But note: converting your after-tax savings to a Roth 401(k) is a permanent change and cannot be undone later.
2). The Mega Backdoor Roth.
As well as converting inside of your plan, the ability to make large after-tax contributions may provide the opportunity to do a “mega backdoor Roth,” converting those contributions out of the plan and into a Roth IRA. This option will provide you with greater flexibility as to how you invest and manage your funds going forward as they will not be ruled by the plan any longer. But the devil here is in the details.
What is a mega backdoor Roth conversion? Quite simply, it’s the employer-sponsored retirement plan equivalent of the backdoor Roth IRA. Since plan contribution limits are higher than IRA contribution limits (2021, $7,000 per year with after-50 catchup), there’s the potential, in limited circumstances, to facilitate a transaction similar to the backdoor Roth IRA, but with much greater dollar amounts.
There are certain conditions that must be met in your plan to be able to utilize this strategy. The plan must allow for periodic in-service distributions of the client’s after-tax money (and their earnings). Not every plan allows for this. To find out what your plan will allow, we recommend starting with a call to your plan administrator.
What Else Should I Be Aware Of?
Beware the pro-rata rules. When a plan contains both pre-tax and after-tax amounts, distributions from such plans must be made on a pro-rata basis. If you are allowed to do in-service distributions, the pre-tax and after-tax portions of that distribution can be split, allowing the pre-tax money to be rolled to a traditional IRA while the after-tax portion is converted, tax free, to a Roth IRA. However, the pro-rata calculation for the distribution generally only includes funds a client is eligible to take a distribution of at the time. If there are certain funds to which a participant is not currently entitled, then those funds are not factored into the calculation.
With the pro-rata rules in mind, a young (aged pre-59 ½, as they usually do not have access to their pre-tax and Roth contributions) client can make after-tax contributions to their plan on an ongoing basis. Then, periodically (and preferably before there are significant gains on those amounts), they can take a distribution of those funds and have them converted to a Roth IRA. Since any pre-tax and/or Roth salary deferrals they have, along with their earnings, would generally be inaccessible, the pro-rata calculation would typically only consider the client’s after-tax funds and their respective earnings. Therefore, the converted funds will be all or mostly after-tax money, and the conversion will be virtually tax-free.
There are a few potential traps and procedures to follow in order to make these transactions work as intended, so be sure to speak with a qualified tax and/or financial advisor first!
Tax-free income in retirement is a great advantage, but a Roth conversion is not for everyone. To decide whether a Roth conversion is right for you, you need to consider your current and future tax rates, among other factors.
About the authors: S. Joseph DiSalvo, ChFC® and Marie L. Madarasz, AIF®
S. Joseph DiSalvo, ChFC® and Marie L. Madarasz, AIF®, authors of “Income for Life, The Retiree’s Guide to Creating Income from Savings”, specialize in coordinating a retiree’s income, investment and tax planning. They are members of Ed Slott’s Elite IRA Advisor Group, a prestigious study group which enhances their knowledge of IRA distribution planning. Both are strong advocates of financial education, seeking to teach others how to achieve sustained success and lifelong prosperity. www.IncomeForLifeBook.com
Also check out the Retirement Daily Learning Center’s How to Know When to Retire.
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