Times were simpler when you retired and pension payments rolled in until the day you died. These days, most of us are responsible for our own saving, investing, and distribution planning. 401(k) plans are available to many but the rules, features, formulas, and options within each can vary widely from employer to employer. If you’re lucky, buried amongst your plan provisions is a rare, but uniquely powerful plan feature named the AfterTax 401(k) or AT401(k).
Only a handful of employers in Greater Boston include the AT401(k) feature in their retirement plans and they’re all big: Google, Raytheon, GE, etc. What’s more, the companies offering the AT401(k) do a miserable job explaining it, leaving it both misunderstood and underutilized.
A Roth 401(k) is different
But the confusion makes sense! Roth accounts are also, technically, funded with after-tax money. To understand where the Roth 401(k) and AT401(k) part ways, let’s review two annual IRS limits:
- Elective Deferrals – 457(e)(15) – For most participants, this defines the max-allowable payroll deduction their 401(k) will accept. For 2020 this max elective deferral is $19,500. If your plan includes the Roth 401(k) option, you can allocate your elective deferral between the Roth 401(k) and the Traditional/Standard/Regular 401(k).
- Defined Contribution Limit – 415(c)(1)(A) – For the purposes of the 401(k), this is the combined max allowable contribution that an employee AND employer can together make to a participants’ 401(k). For 2020 the defined contribution limit is $57,000.
Vastly Expanding Tax-Sheltered Contributions
Let’s say in 2020 you make your max elective deferral of $19,500 and your employer provides matching funds of $6,000. Subtracting the sum of those two figures ($25,500) from the 2020 defined contribution limit of $57,000 leaves you with $31,500. If your plan allows it, you can save an after-tax amount of up to $31,500 (in addition to the elective deferral of $19,500) into your AT401(K).
Consider the family where both spouses work, both spouses contribute the max $19,500 elective deferral, but still have the cash flow to support additional investments for retirement. For most folks without an AT401(k), the best option is to save into a taxable investment portfolio. We call these “taxable” to highlight the fact that interest, dividends and realized gains are taxed annually; whereas, the growth and realized gains in tax-sheltered investments like the 401(k), IRA, and Roth is not taxed but allowed to compound until distribution. The AT401(k) is just such a tax-shelter, but wait, it gets better.
Roth Conversion of AfterTax 401(k) Contributions
The exact mechanics of converting your AT401(k) contributions into Roth funds vary from plan to plan, but, at the absolute latest, when you leave your company, you can roll your AT401(k) contributions into a Roth IRA. Growth in excess of your contributions can be rolled into a Traditional IRA. Other plans allow you to make the Roth conversions much sooner. Some plans allow participants to elect auto-conversion of each AT401(k) contribution. This automatic “In-Plan Roth Conversion” is preferable since both the contribution and future growth all reside in the Roth instead of being divided out later. Other plans allow for in-service distributions to IRAs, which is still better than waiting until you leave the company to segregate the principal from growth. Regardless of the mechanics, the AT401(k) provides a massive tax-shelter for additional retirement savings for those with the means to fund it.
Tell Your Company’s Decisionmakers
What’s odd about the relative scarcity of the AT401(k)’s out there is that few people would benefit more than those who decide on the features of their company plan. Most of my clients max out their elective deferral and still invest in taxable portfolios. I rather imagine most C-suite executives do the same. Why wouldn’t they add an AT401(k) to their plan, thus dramatically raising the tax-deferred savings ceiling available to them and their employees? I suspect that most decisionmakers just don’t know it’s an option. It might also be costly to implement and/or maintain. But those seem like relatively low hurdles given the earners/savers who this feature benefits the most.