A Different Way to Save

Art by Ryan Peltier

Francis Investment Counsel LLC has several employer clients that allow after-tax, non-Roth contributions to their 401(k) plan. “For those employers, the appeal is mainly the ability for highly compensated individuals to put more money away for their retirement,” says Kelli Send, a principal and senior vice president at the Brookfield, Wisconsin, advisory firm. “Combined with the ability to do an in-plan conversion to a Roth feature immediately, it’s an attractive idea for people who want to save more money in their Roth and the Roth contribution limits don’t let them save as much as they’d like.”
The after-tax, non-Roth savings feature potentially also could be a way for a broad spectrum of employees to put aside money for emergency savings, Send says. “Both of these types of approaches can be a great benefit for participants.”

Why It Works

Twenty-one percent of plans included in Vanguard’s “How America Saves 2022” report made after-tax employee-elective deferrals available to participants in 2021. The after-tax option is more likely to be offered by large plans. One-third of participants had access to the feature, and 10% who were offered it took advantage of it, the report says, noting that those participants tended to have higher incomes and longer tenures.

An after-tax savings feature potentially can allow participants to contribute much more to their retirement savings, says Christine Benz, director of personal finance at Morningstar Inc. in Chicago. A participant may contribute a total of $20,500 annually, or $27,000 if over age 50, to a 401(k) account. But if someone’s plan allows after-tax contributions, there is no specific IRS limit on the amount. Instead, the overall 415(c) annual total contribution limit—including a participant’s pre-tax, Roth and after-tax contributions, as well as the employer’s contribution—comes into play, Benz says.

The 415(c) limit allows total contributions for an individual of up to $61,000, or $67,500 for people 50 and up, this year. So in a plan permitting after-tax contributions, a participant under age 50 who contributes $20,500 and receives $10,250 in an employer match could then save another $30,250—assuming there are no plan-testing complications—in after-tax contributions before reaching the $61,000 limit, she says.

People have few opportunities to save for their retirement on a pre-tax basis, says Steve Feinschreiber, senior vice president and head of methodology at Fidelity Investments in Boston. Affluent investors need to save after-tax. “They may contribute money to a traditional IRA [individual retirement account], but the amount they may contribute annually is fairly small: $6,000—or $7,000 if someone is 50 or older,” he says. “Whereas, if they make an after-tax contribution to their 401(k), the amount of headroom left for contributions [there] is going to be greater,” he says, also citing a potential $30,000 additional savings. “So participants could generally put in a lot more money [in-plan] than they could in an after-tax account outside their plan. And often, the fees are better in the 401(k) plan.”

Issues for Advisers to Consider

Why would an adviser suggest a plan sponsor add the after-tax, non-Roth savings feature? As a means to save more money for retirement, “it’s really attractive to higher-income workers,” Benz says. “If a plan can offer it, it’s a key benefit that can help entice employees to work at a company.”

There has also been some talk in the industry about utilizing an after-tax savings feature as a sidecar-savings account to accumulate emergency savings, Send says. That might also appeal to non-highly compensated employees who want to save for emergencies, she says, but the IRS’ rules on withdrawals complicate this.

Send offers an example: Say a participant contributes $2,000 on an after-tax, non-Roth basis for emergency savings, and, by the time the person needs to withdraw and use that money, it has grown to $2,200. He could withdraw the original $2,000 contribution tax-free but must pay taxes on the $200 gain. Moreover, if the participant is under 59.5 years old, she says, the IRS considers the $200 account as gain, taken out as an early withdrawal, and the individual would additionally be charged 10% on the $200. “The participant either has to leave the $200 in the plan or pay the premature-withdrawal penalty,” Send says.

IRS rules also complicate the goal of offering an after-tax, non-Roth vehicle as a way to turbocharge higher-earners’ retirement saving. Adopting after-tax contribution capabilities requires a plan amendment, and, once that is implemented, it triggers a nondiscrimination testing requirement for both safe harbor and non-safe-harbor plans, says Anton Brog, a partner in Wagstaff & Crawford, an advisory and third-party administration firm, in Midvale, Utah.

Brog calls the testing implications “the elephant in the room” when thinking about allowing after-tax, non-Roth contributions. “Every plan is going to face that issue: the need to do testing,” he says. The same senior executives who read articles about the after-tax savings concept and advocate for adding it as a plan feature “very often are the ones who end up getting a refund of their excess contribution after the plan fails testing,” he says.

When clients have told Wagstaff & Crawford that they would like to consider adding after-tax, non-Roth savings, Brog and his team look at that plan’s census data to project the testing results if it does begin allowing these contributions. “Our experience is that these plans would not pass the nondiscrimination testing,” he says. “There is much discussion, and ‘smart’ online posts about it, but there are very few plans—in our experience—with the demographics to pass the tests to allow the adoption of after-tax contributions.”

If a plan can add this feature and pass nondiscrimination testing, it is a wonderful benefit for participants able to use it, Feinschreiber says. “But it’s not always possible for an employer to offer an after-tax 401(k) savings option, or, if a plan does offer it, the money participants can put aside may be limited,” he says.

To pass testing, the highly compensated participants in a plan may contribute an average of no more than 2% above the average contributions of non-highly compensated participants. “And who will be making these after-tax contributions? It’s mainly the highly compensated individuals,” he says. “So, many executives may find that their ability to make after-tax contributions will be much more limited than what they thought.”

Wagstaff & Crawford has one plan client that has successfully implemented an after-tax, non-Roth savings feature. The plan has about 60 participants, for a 95% participation rate, and uses both automatic enrollment and automatic escalation. The employer makes both an enhanced safe harbor match and a substantial profit-sharing contribution, which motivates participation. The company has low employee turnover, so many participants stay long enough to accumulate substantial retirement savings. The business owner also advocates, alongside employees, for the plan and encourages them to meet with Wagstaff & Crawford.

“Non-highly compensated employees in this plan already are saving at a high rate, so it raises the floor for nondiscrimination testing,” Brog says, referring to the 2% allowable difference between the average contributions of each group. So HCEs may contribute more, without testing problems.

“An adviser who wants to be proactive with clients may look for these characteristics in a plan,” Brog continues. “It’s probably a better way of approaching the idea of after-tax contributions, instead of approaching every client. I’d suggest identifying the employers that this could work well for first, and then approach the plan sponsor.”

The Appeal of Mega-Backdoor Roths

“[Making] an after-tax 401(k) contribution can be a great option, especially for people who work at companies where participants may do an in-plan conversion to a Roth feature, Feinschreiber says. The conversion option could allow someone to transfer the after-tax contribution to a Roth feature while still in active service, let the money grow, then, in retirement, withdraw both the original contribution and the appreciation tax-free.

Known as a mega backdoor Roth, this strategy is popular with HCE participants.

“If they leave the money in after-tax [without a Roth conversion], they’d pay taxes on the earnings when they withdraw the money but not on the original contribution,” he says. “And the earnings would be taxed at the ordinary income-tax rate, not the capital-gains tax rate.” For an affluent investor, he says, that might mean a sizeable tax bill. He cautions that participants always should consult their tax expert before deciding whether to do the Roth conversion.

A plan with an after-tax contribution feature does not have to also offer in-plan Roth conversions; however, the ability to do a mega-backdoor Roth contribution while still an active participant is frequently the appeal of making these contributions, says Benz. Someone can make an after-tax contribution, then utilize an in-plan conversion feature to immediately transfer that money into the plan’s Roth feature.

“Not only will that person enjoy a tax-free Roth distribution in retirement, but Roth money is not subject to RMD [required minimum distribution] rules,” she says. “You can get more money into a Roth than if you contribute it into a Roth IRA. What you can put into a Roth this way makes the Roth IRA contribution limit seem like chump change.”

… in a plan permitting after-tax contributions, a participant under age 50 who contributes $20,500 and receives $10,250 in an employer match could then save another $30,250—assuming there are no plan-testing complications—in after-tax contributions before reaching the $61,000 limit.

$20,500

after-tax

contribution

$10,250

employer

match

Save

another

$30,250

$61,000 limit