Take It Past the Limit

You know about the benefits of saving in a workplace retirement plan. After all, putting aside money is great; directing it into a tax-advantaged account is even better. But clients may be able to save their employees even more. The annual contribution limit is not the end of their tax-advantaged saving opportunities.

What could be a useful strategy to suggest to a company with high earners is voluntary after-tax retirement savings accounts. Making after-tax contributions allows the saver to invest more money, with the potential for tax-deferred growth.

For comparison: 401(k)s and Roth 401(k)s have an IRS saving limit of $19,500 for elective deferrals for those under age 50, and $26,000—including catch-up contributions—for those 50 and older; the after-tax accounts are subject to the IRS overall plan maximum contribution caps of $58,000 for all contributions for those under 50 and $64,500 for those 50 and up.

According to the IRS, a person using such an account would make after-tax contributions, and, when he takes his money out, none of those contributions would be taxed. Unlike with a Roth 401(k) or individual retirement account (IRA), though, earnings would be taxed.

In December 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act increased the age at which people must take required minimum distributions (RMDs) from their 401(k), from 70.5 to 72. Americans, accordingly, have more time between when they retire and must begin their RMDs. An after-tax retirement savings account can bridge that gap nicely, says Wilson Coffman, president of Coffman Retirement Group in Huntsville, Alabama.

And, just as people who expect to face higher taxes in retirement gravitate to Roth accounts, the hybrid approach of an after-tax account permits at least some of their money—their contributions—to sidestep taxes in retirement, he says.

Who Can Benefit?

Less than 10% of Coffman’s clients offer this option, typically due to its complexity.

“[These accounts] are complex mainly due to the tax ramifications,” says Rafael Rubio, president of Stable Retirement Planners, in Huntington Woods, Michigan. “Because you’re commingling after-tax contributions with the rest of your retirement funds, you have to pay more attention to how each [type] is taxed.”

Additionally, says Coffman, if the company has relatively few highly compensated employees (HCEs), their greater savings will make the plan fail its nondiscrimination testing, and it will need to return the excess contributions.

Stable Retirement Planners has clients that offer after-tax retirement savings accounts—mostly these are doctors’ offices and law firms, which have a preponderance of HCEs and want to attract talent, Rubio says. But he stresses the need for well-qualified financial advisers to help with this type of account.

Other employees who would benefit might be a company salesforce paid by commission, whose income varies greatly from year to year, says David Swallow, managing director, consulting relations and retention, with TIAA in Tampa Bay, Florida. “These kinds of accounts make people’s money more available for withdrawals, depending on the plan document,” he says. “Such an account would give the employees a great opportunity to contribute on an after-tax basis when they’re making more.”

Back Door Roth

Another attractive feature of after-tax retirement savings accounts is the back-door Roth option, and “it has gotten much attention in the retirement savings industry,” says Jason Grantz, institutional retirement consultant at American Trust in Lexington, Kentucky. “It’s potentially a way for high earners to be able to take advantage of a Roth-type deferral strategy beyond the Roth deferral limit.” The idea, he explains, is to contribute one’s first $19,500 into a Roth; any amount above that would be a voluntary after-tax contribution. The back-door Roth then lets the investor convert those monies into a Roth, thereby changing the status of the earnings from tax deferred to tax free.

“Of course, any earnings that have already accrued would be taxable in the tax year of the conversion,” he notes. “If this is done quickly after the contributions are made, the earnings may be so small as to be de minimis or negative from a current tax perspective. Due to income limitations on Roth IRAs[—i.e., modified adjusted gross income of $140,000 for single filers and $206,000 for married couples filing jointly—]the retirement plan may be the only place an individual has to invest in a Roth.”

Lay the Foundation

If the plan document does not already allow for adding after-tax savings accounts, the sponsor may amend it and other corresponding documents, Swallow says.

“The sponsor would then work with its payroll provider to set up a separate type of contribution where it can track after-tax separately from pre-tax and Roth,” he says. Further, the sponsor, with its recordkeeper, should set up a separate money bucket to hold after-tax contributions for tax purposes and keep track of which funds are contributions and which are earnings, he says. “Then, it would need to ensure that its payroll provider and recordkeeper share information.”

Finally, should a sponsor offer after-tax accounts, it needs to make certain that its employees fully understand them, particularly the tax ramifications, says Stan Milovancev, executive vice president with CBIZ Retirement Plan Services in Cleveland. “They need to understand that after-tax contributions are not treated the same as a qualified Roth account, and that they have the ability to access these contributions more easily and without the penalties that would be associated with withdrawing funds from a Roth account early.”

Provisions for saving nearly three times more than in a regular 401(k) or Roth 401(k) can appeal to some clients and it’s an option advisers serving professionals should consider suggesting.

Savings Limits, 2021

Based on a $180,000 per year salary, an employee 50+ could defer $64,000 to an after-tax account. An employee under age 50 could defer $58,000.

Note: For illustrative purposes only; your client’s match may be different; your client may not offer an after-tax savings opportunity or profit sharing.
Source: Fidelity Investments

Art by Aya Kakeda