Gary W. Pelletier, CLU, ChFC, AIF®

Northeast Planning Associates, Inc.

Corporate, Estate

& Financial Planning


Are After-Tax Contributions to Your 401(k) a Good Idea?

| March 24, 2017
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If I asked you: “What is the maximum amount you are allowed to contribute to your 401(k) this year?” you would most likely answer either $18,000 or $24,000 depending on your age (50+) and ability to contribute an additional $6,000 as a catch-up amount.

You would be partially right.  Those amounts above are the annual limits for pre-tax or Roth contributions to a 401(k) plan.  However, some plans allow additional after-tax contributions up to the 2017 IRS limit of $54,000.  These after-tax contributions (not to be confused with Roth 401(k) contributions) are not new, but 2014 legislation on how those after-tax monies are handled make utilizing this strategy much more attractive.

Notice 2014-54 clarified the IRS’ position on allowing the splitting of pre-tax and after-tax monies when rolling a 401(k) over to IRAs.  Essentially, if a plan allows for it, after-tax contributions can be specifically segregated to be rolled to a Roth IRA without any tax consequence, which provides an aggressive saver greater access to the benefits of a Roth than would be the case if they simply relied on direct Roth 401(k) and Roth IRA contributions. 

Prior to the new regulations, once no longer employed by the company that offered the 401(k), investors had to engage in a series of complicated maneuvers to segregate their after-tax dollars from their pre-tax in an effort to get them into a Roth IRA.  Now the after-tax contributions can be rolled directly to a Roth IRA and pre-tax contributions and all earnings can be rolled to a Traditional IRA. 

While an obvious benefit of after-tax contributions has always been the tax-deferred compounding of returns on these monies, Notice 2014-54 makes the backend of this strategy much cleaner.  If a high-earning individual maximized their Traditional or Roth 401(k) contribution at $18,000 (and we assume that they are not eligible to contribute to a Roth IRA directly), they may want to save more money for retirement.  This person could of course save additional monies into a taxable investment account, and their advisor could help them plan for the taxable impact of these investments through things like Municipal Bonds and/or ETFs. 

A taxable investment account would be needed if there was not enough liquidity available already.  However, if there was enough liquidity from other assets for an emergency or accumulation goal, this person instead could save after-tax dollars up to $54,000 total (including their $18,000 max contribution and any Employer contribution/match) in their 401(k) and reap the benefits of tax-deferred earnings.  So while there is no substitute for pre-tax or Roth 401(k) contributions, making after-tax contributions may be a good idea for those who want or need to save more than is allowed under current limits. 

Content in this material is for general information only and not intended to provide specific tax, legal or financial advice or recommendations for any individual. No strategy assures success or protects against loss. Investing involves risk including loss of principal. Since this communication introduces an IRA as a suggested strategy, please define for clarity: The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 1/2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Since this communication discusses rolling money out of a plan and into an IRA, for balance please add: A plan participant leaving an employer typically has four options (and may engage in a combination of these options), each choice offering advantages and disadvantages.

These options include:

  • Leave the money in his/her former employer's plan, if permitted;
  • Roll over the assets to his/her new employer's plan, if one is available and rollovers are permitted;
  • Roll over to an IRA; or
  • Cash out the account value

 

 

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