After Tax Contributions
Written by Rick Huff
This Is Big – Really Big
Every so often, situations arise that provide tremendous opportunities to both save and reduce our taxes. Far too often we gripe about taxes, the complexity of the tax code, and the fact that we have to pay taxes at all. Instead, we should be educating ourselves on the many ways to lower our annual contributions to the Treasury Department. Don’t forget, the tax code does provide a multitude of ways to save along with lowering taxes.
Enough ‘soap box preaching’; back to the importance of the article. This opportunity is so big that it requires reacquainting ourselves with some tax basics to grasp and realize its importance.
Let’s quickly review the concept of tax buckets, which are –
- Taxable – you are taxed currently on all earnings
- Tax deferred – contributions are deductible with earnings not taxed now, but all future withdrawals are taxed
- Tax free (the best bucket) – all earnings are tax-free as are all future withdrawals.
Most people know that Roth accounts are the tax-free bucket; meaning all earnings and appreciation are tax-free now and when withdrawn in the future. For some reason Congress gave us the option of Roth accounts but then severely limited our ability to contribute. Makes a lot of sense doesn’t it?
Without getting extremely technical, several recent tax acts have created a perfect storm for individuals to save material amounts of money in the tax free bucket, garnering tax free growth and tax free withdrawals in the future. (Pay attention to all the instances “tax free” was used.)
This opportunity has come in the form of ‘after-tax contributions’ into your employer sponsored 401(k) account coupled with ‘in plan Roth conversions’. In other words, your employer’s retirement plan/401k must have adopted these features for you to take advantage of this bonanza.
The basics are –
- participants contribute after-tax dollars into their retirement plan account
o these are not subject to the normal deferral limitations
- participants then do an ‘in plan Roth conversion’
o this step permits the ‘converted’ monies to grow tax free
Let’s look at an example to see the potential.
John Doe, age 45, works at ABC Company. John is blessed with a good job; he has been able to defer into the company’s 401k, and can save personally. John is deferring the maximum into his 401k, which for his age is $18,000. John’s company also contributes to the plan on his behalf, throwing in another $4,000.
Because ABC Company recently amended their plan permitting after-tax contributions and in plan Roth conversions, John elects to contribute an additional ‘after tax’ amount each pay period/month. Shortly after each contribution, John “converts” those amounts into Roth dollars.
At his age, John can contribute an additional $31,000 each year to the after-tax portion of his plan.
Once John turns age 50, he can defer up to $24,000 pre-tax along with getting his company’s portion, $4,000. John’s after-tax contribution remains at $31,000.
The benefits are astounding. John was going to personally save and invest the additional $31,000. As these savings would have accumulated, John would be taxed on interest, dividends, capital gains and capital gain distributions. Now, there is no taxation on any of this income; accumulations will all grow tax free. At retirement, John rolls over his tax deferred 401k monies to a traditional IRA with any withdrawals taxed. However, at the same time, John rolls over his after-tax funds to a Roth IRA, where they continue to grow tax free, with no withdrawal requirements, limitations and NO TAXATION.
As you might guess, above is the condensed ‘Reader’s Digest’ description of this new retirement plan feature that is being adopted by larger employers. It is so new, some of the HR/Benefits departments, along with their investment providers, are unaware of its existence, mechanics and advantages. Additionally, there are a number of strategies and tactics that can be piggybacked along with after-tax contributions that can significantly improve your financial situation.
If your employer notifies you about the existence of ‘after-tax’ contributions now available with your retirement plan, contact us and we’ll research its capabilities and how we can maximize the benefit for your financial life.
It is an opportunity you can’t afford to miss.