Late last year, the Internal Revenue Service published new rules for in-plan Roth conversions. The updated guidance explained how to transfer account balances to after-tax Roth inside a retirement plan and affirmed that essentially all vested accounts were eligible for this conversion. Coupled with a decades-old provision which allows participants to make after-tax employee contributions in addition to their salary deferrals, this development created a unique planning opportunity. For many, Roth paves the way to retirement income security. And, who doesn’t like tax-free income?
After-tax Contribution 1.0
After-tax employee contributions, also known as voluntary after-tax employee contributions, have been in existence for a long time (not to be confused with Roth 401(k) deferrals which came into the picture in 2006). Historically, after-tax contributions enabled participants to direct additional funds into their retirement accounts, on top of pre-tax 401(k) salary deferral savings. These non-deductible contributions didn’t count against the annual deferral limit, but grew tax-deferred, and were only taxed on earnings when withdrawn.
Imagine this scenario: Bob, age 45, already takes full advantage of the 401(k) plan salary deferral limit by saving $18,000 per year in his company’s retirement plan; his employer makes a matching contribution of $3,000. The plan allows participants to make after-tax contributions. In 2015, the IRS annual defined contribution plan deposit limit is the lesser of $53,000 or 100% of compensation. Bob can make an after-tax contribution of up to $32,000 into his account: $53,000 reduced by $18,000 deferral and $3,000 employer match. This contribution will be made with after-tax dollars, and earnings will be tax-deferred until withdrawn. That is how the after-tax contribution 1.0 works, now with in-plan conversions, Bob can take this approach to a whole new level.
With expansion of internal Roth conversion rules, a participant can make a non-Roth after-tax contribution and immediately convert that balance to Roth inside the plan. The conversion will allow the earnings to accumulate on a tax-free basis and be distributed tax-free, provided the distribution is qualified (taken after the later of attainment of age 59 ½ and 5 years from the year of conversion). Using the earlier example, Bob can immediately convert his after-tax deposit to Roth inside of his plan. This transaction will be penalty and tax free.
Who Can Benefit
There are three distinct client profiles that may benefit from this opportunity:
- Client wants to increase tax-free retirement assets for tax diversification purposes or to catch-up on savings
- Low plan compensation prevents the client from reaching the annual maximum
- Deduction limit applicable to some 401(k) profit sharing and defined benefit /cash balance plans combinations precludes owners to get to the annual 401(k) plan maximum
Let’s see how it works in these case studies:
Dana: Tax-free Growth
- Dana is a self-employed consultant; she accumulated a substantial 401(k) plan balance over the years
- To diversify the tax treatment of distributions in retirement, Dana adds after-tax contribution, Roth 401(k), and Roth conversion features to her retirement plan and structures her funding as follows:
- $18,000 Roth 401(k) deferral
- $20,000 profit sharing contribution
- $15,000 after-tax employee contribution converted to Roth (if desired, she can eliminate the profit sharing contribution and instead make a $35,000 after-tax contribution)
- By making an after-tax employee contribution and immediately converting it to Roth inside the plan, Dana is able to provide a substantial boost to her tax-free account balance and overcome the Roth 401(k) contribution limit.
- High-income earning clients who participate in their employer-sponsored plans may also be able to take advantage of this opportunity, provided the plan offers after-tax contribution and in-plan conversion features. That said, if an in-plan conversion is not an option, they still may want to take advantage of after-tax contributions and determine at the time of distribution whether they wish to convert the associated earnings to Roth or send the after-tax balances to Roth directing the tax-deferred earnings to a rollover IRA. This is another brand new opportunity clarified by the IRS in late 2014 (click the link to get an overview).
Mark: Break through Compensation Limit
- Mark’s S-corporation establishes a 401(k) plan
- As a shareholder employee, Mark takes his compensation as W-2 wages ($100,000) and shareholder distribution reported on Schedule K-1 ($125,000)
- Since in S-corporations only W-2 wages are treated as plan compensation, Mark’s plan funding is limited to $43,000
- By making an after-tax contribution of $10,000 (and converting it to Roth), Mark is able to reach the $53,000 annual contribution maximum while creating a tax-free source of retirement distributions:
- $18,000 pre-tax 401(k) deferral
- $25,000 profit sharing contribution (25% of Mark’s W-2)
- $10,000 after-tax employee contribution converted to Roth
Barbara: Maximizing Benefit from Combination Plan Design
- Barbara’s company maintains an individual 401(k) plan in combination with a cash balance plan
- Because of the special deduction rules applicable to plan combinations, Barbara’s profit sharing funding is limited to 6% of her compensation
- By using after-tax employee contributions, Barbara overcomes the combined plan limit because her after-tax employee contributions do not count against the 6% annual deduction limit:
- Cash balance Plan: $100,000
- Individual 401(k): $59,000
- $23,000 pre-tax 401(k) deferral and catch-up
- $15,900 profit sharing contribution (6% of Barbara’s pay)
- $19,100 after-tax employee contribution converted to Roth
Since employee after-tax contributions are not salary deferrals, they can effectively become a Roth 401(k) substitute in situations where an individual participates in her employer-sponsored plan and also has an individual 401(k) as a self-employed independent consultant. Since the law limits the annual salary deferral to a single amount across all plans in which a taxpayer participates, $18,000 (2015), after-tax contribution can be used as a back-door Roth 401(k) contribution.
In order to support this approach, certain document parameters and operational requirements must be followed:
- Plan document must allow after-tax contributions, Roth contributions, and in-plan Roth conversions
- After-tax contributions and earnings need to be tracked separately from other account balances
- Each Roth conversion amount and associated earnings also need to be tracked separately from other account balances, including Roth 401(k), and other conversions
- Plan document will typically specify a procedure for making after-tax employee contributions
- When it comes to discrimination testing, after-tax contributions are tested together with employer match. Safe harbor feature does not alleviate this test for matching contributions. For this reason, this method works best in owner-only plans which are exempted from this test; nonetheless, plans with substantial non-owner participation and/or generous match may also be able to take advantage of this strategy.
A Word on Tax Consequences
- When an after-tax employee contribution balance is converted to Roth via an in-plan conversion, the amount of the after-tax contribution is converted tax-free; any appreciation between the deposit and conversion time is includible in income. If the conversion is implemented shortly after the contribution, e.g. the following day, the tax consequences can be minimized if not avoided altogether.
- For those converting prior to attainment of age 59 ½, there is a waiver of the 10% penalty for in-plan Roth conversions.
- In-plan Roth conversion cannot be undone, unlike conversion of a pre-tax IRA to Roth IRA.
- For converted assets to be distributed free of tax, they must be taken upon attainment of age 59 ½ and only after 5 years following conversion. The five-year period for distribution purposes starts in the year when the first Roth dollar is deposited into participant’s account; it can be a Roth 401(k) contribution or conversion. It does not restart with each subsequent contribution and/or conversion. This is often referred to as a five-year clock for tax-free distribution of earnings.
- There is another important five–year clock which starts with every conversion; it is a five-year period for recapture tax purposes. If a distribution is not qualified, then it may be subject to a recapture tax determined separately with respect to every conversion. This period is tracked independently from the five-year clock for qualified distributions.
After-tax contribution feature coupled with expanded in-plan conversion rules open new planning possibilities for planning with Roth balances for small business owners and high income earning employees who contribute to their employer-sponsored retirement programs. Since Roth dollars appreciate tax free, and there’s no tax for qualified distributions, individuals will be in a better position to manage their distributions and marginal tax rates in retirement.