IRA

SECURE 2.0 Act

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In late December, as part of budget appropriations for 2023, Congress passed and President Biden signed into law, the SECURE 2.0 Act.  For those interested in the full text, see Division T of HR 2617.  It can be found on pages 2046-2404 of the 4,155 page document.  SECURE 2.0 is an add-on to the original Setting Every Community Up for Retirement Enhancement (“SECURE”) Act of 2019, most of which went into effect in 2020.  SECURE 2.0 is filled with a ton of tax, retirement, and other provisions, many of which are extremely complex and will require additional guidance from the IRS on implementation.  Below are the provisions I noted that are most likely to impact some PWA clients, now, or in the future (I tried to sort these in order of most interest to least for the average client, so the more important ones are listed first.  This makes the list NOT follow the sections of the bill at all).

  • Rollover of unused 529 plans to Roth IRAs – SECURE 2.0 allows for penalty-free rollovers from a 529 plan to a Roth IRA for the beneficiary of the 529 under certain circumstances.  The lifetime limit is $35k per beneficiary, but annually, can’t be more than what the beneficiary could contribute to a Roth IRA (that may or may not include the need to have earned income… we’ll need more guidance on that).  The 529 account must have been open for at least 15 years to make such a transfer and the transferred amount must have been in the account for more than 5 years (i.e. you can’t contribute and then immediately convert…  this is really intended for leftover education savings after school is complete).  Interestingly, there are no income limits to making these rollover contributions, so we have another “backdoor Roth” type opportunity.
  • RMD begin date – Required Minimum Distributions from pre-tax retirement plans must start in the year that a taxpayer turns 72 (up from 70.5 due to SECURE 1.0).  SECURE 2.0 extends this to age 73 starting in 2023 and to 75 starting in 2033.
  • Missed RMD penalty reduced – from 50% to 25%, or 10% if the correction occurs in a timely manner (generally, within 2 years).  Starts in 2023.
  • Additional 401k catch-up contribution – for those ages 60-63, the catch-up contribution amount is increased to $10k (from the current $7500) or 50% more than the regular catch-up contribution, whichever is greater, starting in 2025.
  • Catch-up contributions must be Roth – Currently, catch-up contributions to a 401k/403b can be pre-tax or Roth as decided by the plan participant.  Starting in 2024, all catch-up contributions must be Roth, unless the participant’s previous year compensation is less than $145k (indexed for inflation).
  • Matching contributions can be Roth – Currently all 401k/403b employer matching is done on a pre-tax basis to a Traditional 401k.  Starting in 2023, plans can allow participants to direct whether they want the match to be contributed to the Traditional or Roth 401k/403b.  If Roth, the match will be considered taxable income in the year the contribution is made.
  • Student loan payments will count for 401k matching purposes – when employers offer a 401k match, if the employee doesn’t contribute to the plan, they don’t get the match.  SECURE 2.0 changes that by allowing employers to count student loan payments as contributions to 401ks for the purpose of calculating how much matching an employee will get.  Starts in 2024.  Another seemingly difficult one from an administration perspective.  I’m sure there will be more guidance on how the employee proves the loan payment to the employer and by what deadline to receive the match.
  • SIMPLE and SEP plans can be Roth – starting in 2023, both SIMPLEs and SEPs can allow Roth contributions (would need a SIMPLE Roth IRA and SEP Roth IRA, respectively.
  • Use of 401k funds in Federally Declared Disasters – up to $22k can be withdrawn penalty-free (but not tax-free) from a 401k for a federally declared disaster.  The amount is taxable over 3 years, to allow the impact to be spread rather than potentially bumping the taxpayer up in bracket in the year of the disaster.  The amount can also be re-contributed within three years and then no tax is due.  In addition, loans from 401ks get a boost if you live in a Federally declared disaster area.  Instead of the max loan being 50% of the vested balance or $50k (whichever is less), it becomes 100% of the vested balance or $100k (whichever is less).  Effective for disasters occurring after Jan 25, 2021.
  • IRA Catch-Up – the extra amount that you can contribute to an IRA if you’re over age 50 will now be indexed to inflation (was previously a flat $1k).  Starts in 2024.
  • Qualifying longevity annuity contracts (QLACs) can be larger – the are annuities that start payment after age 72.  Previously limited to 25% of account value or $125k max, up to $200k can now be purchased and is exempted from Required Minimum Distributions (RMD).  Start is in 2023.
  • Qualified Charitable Distribution (QCD) easing – SECURE 2.0 indexes the $100k annual QCD limit to inflation, and allows a one-time $50k QCD to a charitable gift annuity, charitable remainder unitrust, or charitable remainder annuity trust.  Starts in 2023.  Note, QCDs can still be made by those over 70.5 years of age, despite the RMD begin date being pushed back from the year you turn 70.5 to 72 (by SECURE 1.0) and now 73 or 75 (by SECURE 2.0).
  • Roth 401k RMDs eliminated – While there has never been a Required Minimum Distribution for Roth IRAs, Roth 401ks did have an RMD.  SECURE 2.0 eliminates this starting in 2024.
  • Retirement plan distributions for Long-Term Care insurance – Up to $2500 can be distributed per year penalty-free (but not tax-free) to pay the premiums for LTCI.  Starts in 2026.
  • Penalty-free “emergency” distributions from 401ks – Can withdraw up to $1k per year as an emergency expense without penalty.  Tax is due unless the amount is repaid within 3 years.  No additional emergency withdrawals are allowed until the amount is paid back or the 3 years has passed.  Starts in 2024.
  • Emergency Savings Accounts – SECURE 2.0 allows (but does not require) employers to offer Emergency Savings Accounts to non-highly compensated employees, linked to their retirement plan.  These would function like Roth 401k accounts (after-tax) with a max of up to $2500/yr in contributions, would qualify for matching, and would allow up to 4 penalty-free withdrawals per  year.  At termination, the remaining amount can be rolled to a Roth 401k or Roth IRA>
  • 401k auto-enrollment – if you start a new job, you may find that more employers are auto-enrolling employees in their 401k, unless they opt out.  SECURE 2.0 mandates this as part of new plan setups, with initial contributions ranging from 3-10% and auto-increase annually up to 10-15%.  Starts in 2024.
  • SIMPLE plan changes – contributions limits will increase by 10% starting in 2024.  Additionally, employers contribute more to employee SIMPLE accounts (up to the lower of 10% of compensation or $5k).
  • Nannie SEPs – Domestic employees can participate in Simplified Employee Pension (SEP) plans.  Starts in 2023.
  • Starter 401k plans – Employers without a 401k (or 403b) can sponsor a starter 401k (or safe-harbor 403b) that doesn’t require any onerous non-discrimination testing.  Employees would be auto-enrolled and can contribute up to the maximum amount that would allowed to an IRA for the given year.  Starts in 2024.
  • Saver’s Credit becomes Saver’s Match – the current Saver’s credit provides a tax credit of 50% of the first $2k contributed to a retirement plan for low income individuals / families.  SECURE 2.0 changes this to a Saver’s Match which is deposited into the saver’s retirement plan account (seems like a much more difficult plan from an administration standpoint, but perhaps it will provide a bit better incentive to contribute as the Saver’s Credit was not a popular program.  Starts in 2027.

Tax Increases & Retirement Funding Limits Incoming

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The House Ways and Means Committee released a tax plan designed to pay for (part of?) the bi-partisan Infrastructure Bill and the larger spending bill that Democrats are trying to pass through a process known as “reconciliation”.  The House tax plan contains fewer tax hikes and fewer changes to the tax code overall than President Biden’s initial plan released earlier this year.  While the President’s plan always seemed unlikely to garner enough support, the House plan has the makings of a real starting point for negotiation.  The Senate is moving forward with its own legislation and eventually, both Chambers will need to pass a bill, then reconcile into one bill which is re-passed.  With the Democrats having slim margins in both the House and Senate (courtesy of the VP tie-breaker there), it will be difficult to get enough support from the progressive and more moderate side of the party at the same time.  They’ll either need to do that or bring some Republicans on board in order to get enough votes to pass the broad package.  In summary, there are bound to be a lot of changes to the details here, but we’re close enough to actual proposed legislation, that I thought it would be a good idea to lay out the key portions of the current proposal.  As a side note, there is a fair shot that some/all of the changes will wind up being last minute, end-of-year, potentially retroactive to this year changes.  The timing of enactment and the effective date of each change are going to determine whether or not any action can/should be taken to minimize the impact of tax hikes, or take advantage of temporary opportunities for deductions, credits, etc.  December is going to be a fun month tax-wise, as it has been for the past several years.  Stay tuned.

Currently Included in the House Plan:

  • An increase in the top marginal income tax rate from 37%, back to where it was pre-TCJA at 39.6%.  In addition, the 32% and 35% brackets would be compressed so that the top bracket begins at $400K Single / $450K Joint.
  • A 3% “surtax” on those earning more than $5M in a given year.  A surtax is just a fancy way of adding to the income tax rate, effectively creating a new top bracket of 42.6% for those earning > $5M.
  • An increase in the tax rate on long-term capital gains (LTCG) tax for upper-income taxpayers (in the top tax bracket for LTCG which starts at ~$450K single / 500K joint) from the current 20% to 25%.  Note: this provision would become effective as of 9/13 if I’m reading it correctly (i.e. sales prior to that date would be taxed at the existing rate, sales on or after would be taxed at the new rate).  If true, there’s no ability to sell in advance, though since the rate is only going up 5%, and that might change in a future administration, I can’t see why anyone would sell anything other than for a short-term need anyway.
  • A decrease in the corporate tax rate from the current 21% to 18% for low-income (up to $400K) corporations and an increase to 26.5% for high-income (over $5M) corporations.
  • Limits on the 199A “20% small business deduction” to a max of $400K Single / $500K Joint.  Those aren’t income limits to take the deduction…  they’re limits on the max amount of the deduction.  There had been an alternate proposal (Wyden plan) to eliminate the Specified Services Trade or Business provisions as well as the W-2 income and unadjusted basis of assets provisions, and instead just institute income limits.  That’s not included in the House plan.  (Of course it’s not…  it would have simplified something!)
  • Contributions to IRAs / Roth IRAs would be prohibited if their value (in aggregate in case there are multiple accounts) exceeds $10M in value and income for the year exceeds $400k single / $450k joint.
  • Add a new Required Minimum Distribution (RMD) to IRA, Roth IRA, and defined contribution (e.g. 401k) accounts (in aggregate) that exceed $10M in value if income for the year exceeds $400k single / $450k joint.  The RMD would be 50% of the amount that exceeds $10M.  Additionally, if the balance of those accounts exceeds $20M, a 100% distribution is required from the Roth portions until the total balance is less than $20M or the Roth accounts are exhausted.
  • Roth IRA conversions and 401k Roth Conversions would be prohibited for those with income over $400k single / $450k joint.  Additionally, after-tax contributions to 401k and the conversion of after-tax contributions to Traditional IRAs would be prohibited regardless of income (i.e. the end of the “backdoor Roth” and the “mega backdoor Roth”).
  • IRAs would not be able to hold 1) private investments that can only be offered to “accredited investors”, 2) securities in which the owner has a >= 50% interest (10% if not tradable on an established securities market), and 3) the securities of an entity in which the IRA owner is an officer.
  • Lifetime gift / estate tax exclusion is reset to its 2010 level of $5M per individual (adjusted for inflation) instead of that happening after 2025 as scheduled by TCJA.
  • Changes to bring most Grantor Trusts back into the estate of the grantor and to eliminate the valuation discount frequently used when gifting portions of family limited partnerships (FLPs) to the next generation.
  • More money for the IRS to boost its audit programs.  Everyone hates and audit, but this is sorely needed.  The IRS lacks the resources to keep up with tax cheats.

Notably Not Currently Included:

  • Increase in the State And Local Tax (SALT) maximum deduction.  This is the cap put in place as part of the TCJA that limits both single and joint filers to a maximum Federal deduction of $10k for taxes paid to states and localities.  Several high-tax state representatives in the House have said they will not vote for any tax and spend package that doesn’t relax the current SALT limit, and House leadership has implied that a change to the SALT deduction is still on the table and may be added to the bill at a later date.
  • Loss of Basis “Step-Up” at death.  This feature of the current tax code allows those who inherit property (real estate, securities, farms, businesses, etc.) to have the cost basis of the property reset to its value on the date of death of the owner.  This allows substantial gains to go untaxed if the property is held until death.  The President’s tax plan would curb basis step up, but such curbs were not included in the recent draft from the House.  The head of the Senate Finance Committee has indicated that this may wind up in the Senate bill, so it’s not dead yet either.
  • Elimination of tax-free loans from securities portfolios.  The current tax code allows owners of brokerage accounts to use the account as collateral to take out loans.  The proceeds from the loans can then be used to support expenses, rather than selling assets and potentially paying capital gains tax on those sales.  This practice helps to avoid selling assets such that basis can be stepped up at death (see bullet above) and capital gains tax is never collected.

The SECURE Act & Tax Extenders

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Over the last week, Congress passed its Appropriations Act, designed to continue to fund the government. To it, they attached the SECURE Act (Setting Every Community Up for Retirement Enhancement) and the extension of multiple expired/expiring tax provisions, known as the “Tax Extenders”. The president is expected to sign the entire bill before departing for the holidays.

The SECURE Act modifies a number of qualified plan (401k, SIMPLE, SEP, etc.) and IRA/Roth IRA rules, along with a couple of 529 plan rules and the treatment of the “kiddie tax”. Below, I highlight the changes along with their likely impact on PWA clients. Virtually all of these changes take place as of 1/1/2020, but unlike the last few tax changes that passed in late December, there is no action that you need to take immediately. If you’re having trouble sleeping, you can read the Secure Act in its entirety on pages 1532-1656 of the Appropriations Act. There are only a few tax extenders that are likely to impact PWA clients. I’ve highlighted those below as well. For the full list, see pages 3-26 of the Division Q amendment to the Appropriations Act.

Secure Act Summary

First a little editorial… the name of the Act (Setting Every Community Up for Retirement Enhancement) and a lot of the press around it is completely misleading in my opinion. The Act’s changes to the retirement system are mostly minor positive tweaks with one somewhat concerning opening of Pandora’s high-cost-annuities-in-a-401k Box (more on that below). It is a far cry from the type of changes that would give everyone access to and the incentive to participate in a tax-advantaged retirement plan. The Act has been sold as “the”, or at least “an” answer to modern retirement issues, but it really doesn’t change a whole lot other than opening a new way for insurers to profit. Call me skeptical, but the insurance industry’s lobby game was strong on this one and when lobbyists step up to the plate in Washington, a home run is rarely a good thing for anyone other than their interest group. So, rather than reading this to see the multiple amazing ways that the Act will help you, please read it to get a sense for the minor positive changes and the couple of things to cautiously look out for in the future. Without further ado, the Secure Act:

· Eliminates a roadblock to Multiple Employer Plans (MEPs) that would allow two or more employers to join a pooled retirement plan, ideally expanding access to plans and reducing costs due to plan size. Pretty self-explanatory and nothing but positives here. Theoretically, this could allow anyone who works for a small business to have a 401k plan available, or a better 401k plan available in the future. Whether or not employers do band together to do this remains to be seen.

· Allows more part-time workers to participate in 401k plans. Specifically those who work 500-1000 hours per year, who were previously excluded from participation, will now be able to participate in the plans. That’s a clear positive for part-time workers and a slight negative for other workers who may see the increased costs to employers as a result of this change passed down to them in some form.

· Increases the business tax credit for new employer retirement plans to $5000 from $500 and adds a $500 credit for auto-enrollment feature. All good incentives that help motivate employers to create retirement plans and get their employees to participate. When compared to the cost of maintaining these plans though (esp. with any sort of matching or profit sharing), it’s honestly still chump change.

· Tweaks the Safe Harbor 401k rules to allow for a higher default employee contribution % while removing notification requirements for plans that make non-elective contributions. Employers can now auto-enroll employees with as much as a 15% contribution level (up from 10%) or with an automatic annual escalation to 15% max. Employees can still opt out though.

· Allows a new exception from the 10% early distribution penalty from a retirement plan for childbirth/adoption within one year after birth, up to a max of $5k per parent. Repayment is allowed to certain types of plans, though the rules are unclear. The increased flexibility is great and maybe more people will participate in employer retirement plans if they can get money back out of them for events like this. But generally, giving people the ability to raid retirement savings for non-retirement reasons isn’t setting anyone up for retirement.

· Eliminates the use of 401k loan “credit card” arrangements. Did you know that some plans adopted provisions that let an employee take out a 401k loan credit card that they could use for any purpose up to the loan limit? That’s not setting anyone up for success in retirement. There are already well-established reasons that loans can be permitted and formal arrangements to make sure participants are taking loans for those reasons only, and are aware of the terrible tax and penalty implications of defaulting on those loans.

· Requires plan administrators to include on quarterly statements an estimate of lifetime income that could be produced at retirement age based on current 401k balance. In other words, if you used your lump sum 401k balance to purchase a straight annuity (series of monthly payments for your life), how much could you expect each month in retirement? I think framing the question in this way is helpful in leading people to realize they may need to save more (or less) based on where they stand.

· Extends the date by which a retirement plan needs to be in place for a tax year from 12/31 of that tax year to the filing deadline of the tax return (plus extensions). This is helpful if you started self-employment or a small business and don’t realize you could benefit from setting up a retirement plan until you prepare your taxes, only to find out that you previously had to open most retirement plans by 12/31 to make a difference. Now you can see the benefit in real numbers and make the decision to open and fund the plan at tax time.

· Allows for portability of lifetime income options in a retirement plan. If the plan decides to eliminate a lifetime income option that was offered, employees enrolled in that option would be allowed to take an in-service withdrawal either by a direct rollover to an IRA or retirement plan or by a distribution to the employee. This is a necessary precursor for the next bullet.

· Provides a fiduciary safe harbor for including lifetime income options using annuities. As long as the cost is “reasonable” and the insurer is thought to be financially capable of satisfying its obligations, the plan sponsor will not be held to the same standards as they are with the selection of other investments in the plan as set forth by the Employee Retirement Income Security Act of 1974 (ERISA). This is the provision that drove the insurance industry lobbying for the SECURE Act. It essentially allows employers (and those they hire to select 401k options) to include annuities in the plan. This is not inherently bad. Some annuities, especially annuities that convert a lump sum into an immediate or future monthly cash flow stream for life, make a lot of sense from some people. But there are also terrible annuity products with monstrous fees that take advantage of consumers with overcomplicated promises dressed up as “guaranteed lifetime income” that really make no sense for anyone, especially not inside an already tax-deferred retirement plan. Now, plan sponsors can be talked into including these options by insurers (who kick back commissions to the plan administrator) and will no longer be held to the same standard as they are for selecting mutual funds. For PWA clients, this isn’t an issue. If you have a new fabulous “guaranteed lifetime income” option in your 401k at some point in the future, we’ll evaluate it like any other option and will likely come to the conclusion that it doesn’t make sense. For those who don’t have an advisor looking out for them as a fiduciary, I fear this new ERISA exclusion is opening up Pandora’s Box just when we’re really starting to get plan fees and mutual fund fees down to something reasonable. I hope I’m wrong.

· Eliminates the maximum age for making an IRA contribution (which used to be 70). This is great as people are generally working longer and if they want to keep saving for retirement past 70, it allows them to do so. But, generally speaking, those who are working past 70 and contributing to their retirement past age 70 aren’t the people who have a retirement savings issue. So, it’s a nice provision, but not sure it really helps a whole lot.

· Changes the Required Minimum Distribution (RMD) starting age to 72 from 70.5 for pre-tax retirement plans (401ks, IRAs, etc.). A nice add, with people living longer, to not have to start withdrawing from their pre-tax money and therefore paying tax for an extra 1-2 years. Not a huge change, but it will have some impact for those that can rely on other sources of money from retirement to age 72 and can use that timeframe to tax-optimize their withdrawals over life (Roth conversions, gain harvesting, minimizing tax on social security income, minimizing Medicare IRMAA surcharges, etc.).

· Ends the stretch IRA. This provision will force inherited IRAs to be liquidated over 10 years in most circumstances, rather than over the lifetime of the person who inherits the account. No RMDs during the first 9 years. You just need to liquidate by end of year 10. Exceptions: surviving spouse, disabled, chronically ill, not more than 10 years younger than the deceased owner, and minor children of the deceased (until they reach the Age of Majority). This is a big negative for most who stand to inherit a 401k or IRA, and that’s intended since this provision is the primary “pay-for” of the bill in its ability to raise tax revenue. It stinks, but it’s hard to argue with it. Deceased people don’t need retirement accounts and therefore the tax benefits that go along with them don’t make a ton of sense for those who inherit them. I’m in the minority of advisors in admitting this, but the change seems fair to me… maybe even generous in giving 10 years. This one has major estate planning implications. If one leaves their retirement accounts to a trust that is directed to pay out only the RMD each year to the trust beneficiary (to minimize tax over their lifetime under the old rules), that trust won’t pay anything out for 9 years and then will pay the entire lump sum in year 10, or worse, will retain it and pay tax at trust rates. Estate plans and the wording of such trusts need to be re-evaluated and potentially re-written. If you have such a trust, or have one that will be created at your death by your will (testamentary trust), and your estate attorney doesn’t contact you shortly, you’ll need to reach out to him or her and evaluate if any changes are necessary.

· Add a new provision that up to $10k (lifetime) can be used from a 529 to pay off student debt without Federal tax / penalty. Another $10k to pay off a sibling’s student debt. State rules differ and will likely follow the same path as they followed on the addition of K-12 private school tuition. Sounds wonderful, but are there really a lot of people who have extra 529 money lying around to pay down their or a sibling’s student loans? It also doesn’t make sense to set up a 529 for this purpose (unless it allows you to game the state tax deduction rules). It would make more sense to just pay down the debt, not contribute to a 529 and hope it grows while the student loans continue to accrue interest at the same time.

· Reverses the Kiddie Tax changes made by TCJA which taxed investment income of minors at estate & trusts tax rates instead of parent rates. Back to parent rates now. This one has nothing to do with retirement. There was just a lot of pushback especially when people realized the Kiddie Tax applies to Military Survivor’s Benefits and the TCJA exposed much more of that to higher tax. Now it’s “fixed” back to the old rules.

Relevant Tax Extenders

· The deduction for mortgage insurance (PMI) expenses returns for those who itemize.

· The threshold to deduct medical expenses for those who itemize is 7.5% of adjusted gross income (down from 10% without the extenders).

· The qualified tuition deduction, which doesn’t require itemizing, is back (max $4k, income restrictions apply as before).

All of the above tax extenders apply for tax years 2019 and 2020. They expire again for 2021 unless further extended by future legislation.

After-Tax 401ks & Rollovers To Roth IRAs

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The IRS recently clarified rules surrounding rollovers of qualified plans (401ks, 403bs, etc., all of which I’ll refer to as “401k”s for the rest of this post for simplicity) to IRAs which can have a dramatic impact on a plan participant’s ability to save for retirement in some situations. For those of you who want to read the official IRS notice, it is Notice 2014-54, released on September 18, 2014. For everyone else (which is probably everyone), I’ll summarize what changed and what it means for you. First some background…

Virtually everyone understands the pre-tax portion of a 401k. You defer a portion of your salary as a deposit to your 401k and that amount is not taxed in the period it’s earned. Instead, it grows tax-deferred until retirement, at which time you can withdraw it (usually after age 59 ½ without penalties) and pay tax at withdrawal. Another, newer type of 401k is a Roth 401k. In a Roth 401k, you are taxed on the income that you defer to your 401k, but it grows tax free and is not taxed at all (under current laws) at withdrawal in retirement. If your tax rate is the same at the time of deferral as it is in retirement, then both types of 401ks produce the same amount of after-tax money in retirement. For most people who are into their mid-earning years, the premise that they’ll earn less in retirement and have more ability to control what portion of their retirement savings is subject to tax each year means they’ll probably be in a lower tax rate in retirement. This means they’d favor the pre-tax “Traditional” 401k. While the generalization is true, in general, like much of financial planning, the details of choosing between a Traditional 401k and a Roth 401k are complicated and really need to be evaluated on a case-by-case basis. Regardless of whether you contribute to a Traditional 401k, a Roth 401k, or a combination of the two, the IRS limits contributions at $17,500 per year (indexed to inflation and likely to increase to $18,000 for 2015) + $5,500 more if you’re over age 50. If your employer makes contributions to your 401k via matching, profit sharing, or direct contributions, a second limit applies. That is that your contributions plus your employer’s contributions cannot exceed $52,000 for 2014 (again indexed to inflation).

In addition to the Traditional and Roth 401ks, there is less well-known and less-popular type of 401k called the After-Tax 401k. Many plans do not allow an After-Tax 401k due to the difficulty in accounting for so many types of contributions. For those that do allow it, in this type of 401k, contributions are taxed in the year you earn them (they don’t go into the account pre-tax like a Traditional 401k), but at withdrawal in retirement, you only pay tax on the growth since you’ve already paid tax on the amounts you contributed. This is much less powerful from a tax perspective than pre-tax in (Traditional 401k) or tax-free out (Roth 401k), but is still advantageous in some cases because it means the growth (interest, dividends, and gains) is not taxed each year as it is earned and so that growth can continue to compound tax-deferred until withdrawal. The After-Tax 401k is not subject to the $17,500 employee contribution limit, but is subject to the $52,000 total contribution limit. This means that if you’re maxing out your Traditional/Roth 401k, and your employer isn’t contributing $34,500, and your plan allows an After-Tax 401k, there is room for you to contribute to your After-Tax 401k. Unfortunately, the tax on the growth of an After-Tax 401k is assessed at ordinary income tax rates rather than at lower, capital gain rates as an ordinary taxable brokerage account would be taxed. So, in general, an efficiently managed taxable brokerage can be a better option than an After-Tax 401k, especially when considering the liquidity advantage that comes with being able to access your money at any point for any purpose. This has been the root cause of the limited popularity and use of an After-Tax 401k.

Once you leave your employer, you can withdraw from your 401k and rollover the money to an IRA. Traditional 401ks go to Traditional IRAs and Roth 401ks go to Roth IRAs, all preserving their tax status. With After-Tax 401ks, it’s more complicated. If After-Tax 401k money is rolled over to a Traditional IRA, a portion of the Traditional IRA becomes “basis”, which is not taxed again at withdrawal and every withdrawal will be part growth (taxed) and part return of basis (not-taxed). If it’s rolled over to a Roth IRA though, the tax treatment used to be unclear. Many tax practitioners and plan administrators thought that the IRS would consider Traditional 401k money and After-Tax 401k money together in one rollover, assessing a prorated amount of tax if one were to try to roll pre-tax money to a Traditional IRA and after-tax to a Roth. This treatment would be consistent with the way the IRS taxes conversions from Traditional IRAs to Roth IRAs. If there are both pre-tax and after-tax (basis) dollars in a Traditional IRA, and you attempt to convert a portion of that Traditional IRA to a Roth IRA, you’d be taxed pro-rata on the amount. Others came up with complicated multi-step schemes to try to isolate the After-Tax portion of a 401k in its own account, such that it could be converted to a Roth tax-free. IRS guidance on Sep 18 clarified that effective immediately, After-Tax 401k dollars can be rolled over directly to a Roth IRA without any tax being due as long as it’s done at the same time as Traditional 401k money is rolled over to a Traditional IRA.

I find it hard to believe that this treatment will be around forever, but at least for now, this has opened the door for massive amounts of money to be tucked away in an After-Tax 401k and then rolled directly to a Roth IRA at the time service with that employer is terminated. Here’s an example of how it could work for someone earning $200k per year, maxing out her Traditional 401k with an 8.75% ($17,500) contribution, receiving a 3% ($6,000) employer contribution, and working for three years before moving on to another opportunity at a different employer:

 

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The person above would be able to stash away $85,500 in a Roth IRA after only 3 years while otherwise earning too much per year to be able to directly contribute to a Roth IRA. It’s clearly not for everyone since you need to have a lot of free cash flow in order to take advantage of the large contributions and your plan needs to include After-Tax 401k contributions as an option. If it can work for you, and you’re looking to tuck away large amounts of tax-advantaged money, this is a really big deal.

So here’s what to do: If you’re maxing out your $17,500 401k contribution each year and looking to put more than that away for retirement, send your 401k plan administrator a note (or call) and ask, “Does my 401k plan allow after-tax (non-Roth) contributions after I’ve hit my $17,500 maximum pre-tax contribution each year?” If the answer is “yes”, you can start to take advantage of this immediately.

One final note to keep in mind… tax rules are always changing. There’s nothing to say the IRS won’t change its mind or that Congress won’t pass a law to stop this treatment of After-Tax 401ks. That’s true of any tax law or IRS interpretation of that law. It’s prudent to monitor the tax landscape and adjust decisions accordingly. Contact your financial advisor before and while attempting something like this or if you have questions about it.