As 2015 opens, clients are beginning to focus on retirement income savings strategies for the year — and many are concentrating on newly available options for maximizing the value of employer-sponsored retirement accounts.
While the non-Roth after-tax contribution option offered wealthy clients a way to increase their 401(k) account values in the past, it did little to mitigate the current or future tax bite. The increasingly widespread availability of in-plan Roth 401(k) rollovers, however, has changed the retirement income planning landscape, creating new opportunities for higher income clients who wish to truly maximize their 401(k) contributions using after-tax dollars.
Despite this, the rules can prove tricky, and small business and individual clients alike should be advised as to the potential impact of using this nontraditional 401(k) savings strategy.
401(k) deferral options
Many clients are unaware that 401(k) contribution options spread much further than the ability to defer the traditional annual pre-tax contribution limit ($18,000 in 2015, or $24,000 for clients age 50 and over). While deferring wages up to this contribution limit is the goal for some clients, in order to truly maximize the 401(k) option, others have sought to take advantage of the non-Roth after-tax contribution limit, which allows the client to defer more than the annual pre-tax limit (for a total of up to $53,000 or 100 percent of compensation in 2015).
Until recently, however, the non-Roth after-tax contribution was a much less viable option even for wealthy clients because these contributions did not reduce current tax liability and, unlike the currently taxable Roth contribution, earnings on the non-Roth after-tax contribution are also taxable.
Small business clients today, however, have the option of allowing in-plan Roth rollovers that can maximize the value of the non-Roth after-tax contribution. To maximize the value of the non-Roth after-tax contribution, the client can contribute after-tax dollars to his or her 401(k), but then quickly convert those dollars to a Roth 401(k) — where earnings can grow tax-free. No early distribution penalties apply to the in-plan Roth rollover as long as the funds remain in the Roth for at least five years.
Further, for clients who have not immediately converted non-Roth after-tax contributions to a Roth 401(k), new IRS rules have simplified the splitting of pre and after-tax contributions into separate accounts. The new IRS rules allow a 401(k) distribution to be treated as a single distribution even if it contains both pre-tax and after-tax contributions, and even if those contributions are rolled over into separate accounts, as long as the amounts are scheduled to be distributed at the same time.
The guidance now allows the taxpayer to allocate pre-tax and after-tax contributions among different types of accounts in order to maximize their future earnings potential — even upon exiting the 401(k) plan.
Practical considerations for the small business client
In order to maximize the value of non-Roth after-tax 401(k) contributions, however, the small business client who controls the 401(k) plan must permit in-plan Roth rollovers. The plan itself can dictate how often a participant is entitled to make an in-plan Roth rollover—and while it might be preferable for participants to have the ability to convert at any time, the small business client must consider the administrative burdens that frequent rollovers could create.
Further, because non-Roth after-tax contributions can be distributed at any time, a rollover notice may be required each time a participant makes an in-plan Roth rollover. As a result, many small business clients should choose to limit the number of rollovers that a participant may make each year in order to make the option administratively feasible.
It’s also important that the plan participants understand the potential ramifications of conversion. Though quickly converting non-Roth after-tax contributions into a Roth can minimize taxable earnings, it is still possible that some additional tax liability may result if the account has generated earnings between contribution and conversion.
Further, the converted amounts become subject to distribution requirements—for example, amounts can only be distributed penalty-free upon the occurrence of certain specified events, such as reaching age 59 ½ or separation from service.
The in-plan Roth rollover rules, combined with the liberalized IRS guidance regarding the separation of pre and after-tax contributions, have created an opportunity for clients to maximize the value of non-Roth after-tax 401(k) contributions—stretching the value of 401(k) accounts to ensure sufficient retirement income later in life.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
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