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Retirement Perspectives

Although IRS guidance was provided several years ago, now’s an ideal time to revisit an underutilized 401(k) plan design focusing on aftertax contributions.

Do you have aftertax dollars in your 401(k)s or similar employer plans?

While many investors generally grasp the rules that apply to pretax and or designated Roth 401(k) contributions and distributions, they are not as familiar with the unique planning opportunities that 401(k) plan participants have with aftertax dollars.

Anyone googling that topic might come across the much-needed and taxpayer-friendly guidance that the IRS published in 2014 (“Notice 2014-54”), which covers distributions of aftertax dollars from a 401(k) and related plans. But in the wake of recently passed tax reform, plan sponsors and their advisors may want a refresher on how 401(k) participants can boost their savings with aftertax contributions.

The big takeaway from the aforementioned IRS notice is that a participant with both pretax and aftertax dollars in his or her 401(k) or similar plan now can allocate the proceeds to different tax-advantaged accounts. In general, the most beneficial outcome will be for a participant to roll over his or her pretax dollars to a traditional IRA and their aftertax funds to a Roth IRA tax free. Put another way, Notice 2014-54 provides an explanation how participants can make a tax-free conversion to a Roth consisting of only the aftertax portion of their plan distributions.

Of course, regular readers of this column know that 401(k) plan distribution rules are a maze of rules and regulations. So, let’s explore:

Suppose Bart recently left his job at Life’s a Dream Inc., where he has a 401(k) account worth $100,000. His account consists of $30,000 of aftertax contributions and $70,000 of pretax dollars and earnings thereon. IRS guidance permits Bart to move pretax dollars valued at $70,000 to a traditional IRA and roll over $30,000 of aftertax contributions to a Roth IRA. Both transactions would be tax free.

Aftertax dollars follow a different and more liberal set of rules compared to pretax or Roth 401(k) distributions, while a participant is still working for the company offering the 401(k) plan.

For example, in-service distribution of both pretax and Roth salary deferrals are only distributable upon the participant reaching 59½, whereas an age restriction does not apply to distributions of aftertax funds and their earnings. Instead, these funds can be distributed at any age—it depends solely on the plan’s rules. Put another way, it’s possible to access aftertax contributions at any time and age as an in-service distribution. Check the plan’s Summary Plan Description for specific rules.

The IRS has in essence blessed the strategy of taking a distribution of aftertax contributions along with any earnings by sending the proceeds to two separate retirement accounts: aftertax contributions (basis) to a Roth and pretax earnings to a traditional IRA.

Tips on Contributing Aftertax Dollars to a 401(k) plan

  • There must be a plan provision allowing participants to make contributions on an aftertax basis. Consider a plan amendment adding aftertax contributions as an option.
  •  Aftertax contributions are not included in the annual salary deferral limit of $18,500 ($24,500, including age 50 + catch‐up). For example, a participant can make aftertax contributions above and beyond the annual salary deferral limit of $18,500 ($24,500 for those individuals age 50 and older). Aftertax contributions would be limited only by the annual additional limit of $55,000 ($61,000 age 50 and older).
  • The plan must permit in-service distributions.
  • Aftertax contributions are subject to nondiscrimination testing in the form of an “Actual Contribution Percentage” test.
  • It is important to note that this guidance does not apply to IRA distributions. An individual who wants to convert IRA funds to a Roth IRA and has aftertax (nondeductible) contributions in any of their IRAs cannot “carve out” and convert only the aftertax dollars to a Roth tax free. Instead, the IRS “pro-rata” rule continues to apply to IRA distributions.
  • Aftertax contributions are not treated the same as designated Roth contributions.

Are you making the best of your (or your clients’) 401(k) contributions and distributions? Feel free to call or e-mail me with any questions that arise.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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