2017 Rules Allow 401(k) Investors to Force up to $60,000 Into a Tax-Free Status

As we’ve written before, investors should pay attention to the asset location strategy of their investments.   THE ROTH IRA IS THE “HOLY GRAIL” OF TAX SMART INVESTING   Maximizing the after-tax return through a smart asset “location” strategy can yield meaningful positive results, which is why Roth IRAs play such a critical role.  Roth IRAs, if handled properly, never create an income tax liability on investment returns, so they can be the perfect vessel for the most tax-burdensome elements of a diversified portfolio.

Over just the last few years, working investors with a company sponsored retirement plan have found themselves with a new option to consider:  the so-called “Roth 401(k)”.  To be clear, there really isn’t any such thing; instead there are 401(k) plans (along with 403(b) and 457 plans) that have chosen to adopt a feature available under the law.  This feature allows a worker to categorize a percentage of their elected salary deferral to receive Roth treatment.  This is a feature of some plans, but not all, and the special tax treatment is not available for any employer funds put into the plan.

The effect over time of electing Roth status for a salary deferral is that the employee is forgoing the current period tax deduction in order to increase the assets in the tax-free category.  Investment returns in a retirement plan accrue to the various funding sources, such as pre-tax salary deferral, post-tax Roth salary deferral, and pre-tax employer contributions.   The investment earnings of the plan that are pro-rated to the Roth source get the identical tax-free status, and the compounding effect means that earnings on the earnings will never get taxed.  With 2017 rules allowing $18,000 in salary deferral plus $6,000 in catch-up contributions for those age 50 and over by the end of the year, the importance of these choices can overshadow the importance of any choices made about contributions to an IRA (which has much lower contribution limits).

But there is yet another important contribution limit that investors should become familiar with; it’s applied to defined contribution plans and is called the Section 415(c)(1)(A) limit.  In 2017 it rose to a whopping $54,000!  How in the world, you might ask, can someone get that much money into a 401(k) plan each year?  You might be lucky enough to have an employer who is making a contribution to your plan, but even if you contributed $18,000 and your employer matched you dollar for dollar (and let’s be real, that’s rare), then that’s still only $36,000 per year.

You may never have known that the tax code allows employees to make after-tax contributions to their employer sponsored retirement plans over and above the normal salary deferral of $18,000.  Your plan may not even allow it, but it should.   The rules allow the employee to add money to the plan after tax (so no current period deduction is taken) until the total plan contribution equals the limit of $54,000 plus the catch-up contribution limit of $6,000, for a grand total for older employees of $60,000!

In the past, this was probably not a good move.  Remember that just like the Roth contribution, the money being used for a post-tax contribution has already been taxed.  But unlike the Roth contribution, which is also post-tax, the earnings do not retain the same tax status as the contribution.   That means that your after-tax contribution will build up earnings that will eventually be taxed at your ordinary income tax rate when withdrawn.  Annuities work like this, which is why they are often a bad tax move.  If that money were simply invested in a taxable brokerage account at least investments that grow in value could receive the preferential long-term capital gains tax treatment.

But there has been an important change in the past year.  Now plans can allow after-tax contributions to be converted to the Roth status as an “in-plan Roth conversion”.  Since the money has already been taxed, converting to a Roth carries no tax bill if done immediately.  In the simplified case where an employee maxes out their Roth deferral and then makes this after-tax contribution up to the limits they could add $54,000 plus the $6,000 in catch-up contributions to their Roth investments.

Real world practicalities that limit this approach are worth mentioning though.  First, your plan may still not allow Roth contributions.   Even if it does, it may not allow after-tax contributions, and if it does then it still may not allow in-plan Roth conversions.  All these plan features may add a bit to the cost of administering your plan or it may simply be that your plan administrator hasn’t paid for the latest software upgrade to accommodate this level of complexity.  You should also remember that your ability to make after-tax contributions is reduced by your employer contribution to keep the total at $54,000 plus the catch-up limit of $6,000, although most people don’t complain about getting free money from their employer.  There is also the more complicated issue of a mandatory discrimination test applied to retirement plans called the ACP (Average Contribution Percentage) test, which is designed to make sure higher salaried employees don’t get too good of a deal.

If this leaves you a bit confused, don’t feel like you are alone.  Many employers forced to make these plan design choices feel burdened by having to explain these options to their employees and just go for the less complicated approach.  But as word gets out among financial planners and HR professionals in corporate America, demand for these features will rise.  You can be part of wave of investors requesting access to these benefits if you contact your benefits department and ask some simple questions:

  1. Does your retirement plan allow you to designate your salary deferral contributions to be Roth contributions (remember, these are made post-tax and don’t get a deduction, but grow tax-free)?
  2. Does your retirement plan also allow you to make  additional post-tax contributions over and above any Roth contributions and catch-up contributions?  If so, to what limits (remember, this may be a bad deal unless you can also get a “yes” answer to the next question too)?
  3. Does your retirement plan also allow you to make in-plan Roth conversions of your post-tax contributions?  If so, can you make a “streamlined election” that causes the contribution to be immediately converted or does it happen at year-end (which may have a tax bill on any earnings converted)?

When you get the answers to these questions, give us a call.  We can walk you through the choices you should consider.  For those investors who earn enough money to increase their savings rate substantially, the long-term financial value of growing their Roth assets is a big deal.  Investors who are lucky enough to have a pension plan, or are worried about the income tax obligations of being forced to take required minimum distributions from non-Roth retirement assets once they reach age 70 1/2, should consider this a form of tax diversification that gives them needed flexibility.  Even the self-employed and business owners who are looking at plan design issues should think about what this could mean for themselves (and their employees) and ask us for help.

One last note:  all of the limits mentioned above are for 2017, and one of the great things about the structure of these limits in our tax code is that they are indexed for inflation.  That means that the numbers will change over time and keep up with the cost of living.   Always check to see what the current numbers are.

At BIP Wealth we always encourage our clients to get the best tax advice they can find from a qualified tax advisor.  

This communication contains general investing information that is not suitable for everyone and is subject to change without notice.  Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass.  The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security.  Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors.