Look at Where the Contributions are Going
One of the more common debates we hear from the investing public is whether it makes the most sense to contribute to a pre-tax or Roth retirement account. While specific situations can favor one option over the other, there is good reason to utilize both buckets.
But something notable is developing; plan amendments are being made to allow for voluntary post-tax contributions.
The third bucket offers employees the opportunity to save post-tax dollars above and beyond the IRS annual elective (employee) deferral limits (in 2019 they allow for up to $19,000, combined of both Roth & pre-tax dollars.) Many plans will also pair this third bucket with an in-plan Roth conversion feature. Essentially, this means that post-tax contributions can be converted into the Roth throughout the year, allowing for tax-free growth moving forward.
Why is this meaningful? Let's take a look at a recent example. We had a prospective client come in earlier this year who was not taking full advantage of their employer benefits. After doing some digging, it turned out that the 401(k) did offer a post-tax contribution option. This afforded the prospective client an opportunity to get more money into their plan simply by rearranging the contribution mix.
At the time, the 401(k) contributions were being directed at the Roth and pre-tax buckets. This was an individual with high household earnings (35% federal tax bracket) and would have benefited more from maximizing pre-tax savings.
As shown below, redirecting all employee contributions to pre-tax results in $2,800 of additional annual tax savings. The tax savings can then be redirected to the post-tax contribution bucket, and converted to the Roth throughout the year. Without the in plan conversion feature, any growth on post-tax contributions is typically classified as pre-tax and taxable upon distribution from the plan.
| Type | $ | Commentary | |
|---|---|---|---|
| Existing Setup | Pre-tax 8% | $12,000 | $4,800 tax savings |
| Roth 7% | $7,000* | n/a | |
| Total | $19,000 | $4,800 tax savings | |
| Proposed Setup | Pre-tax 13% | $19,000 | $7,600 tax savings |
| Roth 0% | $0 | n/a | |
| Post-tax | $2,800 | n/a (note - to be converted within plan to Roth) | |
| Total | $21,800 | add'l $2,800 into plan (extra tax savings from more pre-tax contributions, nothing out-of-pocket) |
(Note that we are assuming an eligible salary of $150,000 and the tax savings are based on a 40% combined federal and state taxes.) *7% is slightly more than $7k but they are capped at annual effective deferral limit.
Essentially, we were able to increase the total contribution by $2,800 without the employee paying any extra out of pocket. Needless to say, use other people's money (especially the government, especially when you're at higher tax brackets) whenever possible.
And by the way, the post-tax contribution is not limited to the tax savings generated. If cash flow permits, an additional $37,000 of post-tax savings (minus any employer match/profit share) can be made in 2019. The total plan limit allows for contributions up to $56,000, significantly above and beyond the $19,000 elective deferral contribution limit. Post-tax contributions are not counted towards the elective deferral contribution limit, only the total plan limit.
So it's worth an inquiry to see if your plan offers this feature. If so, consider your existing contribution setup and whether or not it makes sense to rearrange things. Additionally, for the plan sponsors out there, please note the impact that post-tax employee contributions could have on nondiscrimination testing.
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Neither Voya Financial Advisors nor its representatives offer tax or legal advice. Please consult with your tax and legal advisors regarding your individual situation.
