Author: Paul A. Carl, CHSA, CPFA^™Vice President, Retirement Plan Consulting, Registered Representative

I can only imagine how many phone calls retirement advisors received in July 2021 about employee after-tax contributions. On July 9, the Wall Street Journal published the article, “A Little-Known ‘Back Door’ Trick for Boosting Your Roth Contributions.”

The article combined two concepts: 1) How additional after-tax contributions to a 401(k) plan can grow tax-free if moved to a Roth account and 2) the “mega-backdoor Roth conversion”. The latter was emphasized by the author’s summarization of a PayPal Holdings founder, Peter Thiel, and his IRA.

For me as the Retirement Geek, the article was really hitting on two similar but unique aspects of Roth attributes. I’ll address Theil’s story first.

As I understand it, Theil invested less than $2,000 of his Roth IRA into shares of a pre-IPO that has grown to a value of better than five billion dollars (yes, billion with a B). Because the investment was made through a Roth IRA, Theil may enjoy tax-free distribution provided he doesn’t take any withdrawals until he reaches at least age 59-1/2. The simplicity of this story is a bit different than converting employee after-tax contributions to Roth. Let’s explore the latter.

IF permitted by the plan, employees may contribute after-tax dollars to their 401(k) account. Ordinarily, those after-tax contributions will grow tax-deferred. At time of distribution, the basis (meaning the after-tax contribution) is not taxable and the growth is taxable. For plans that include in-plan ROTH conversions, the idea is to exercise the in-plan Roth conversion on the after-tax contributions into Roth. Thus, immediately or nearly immediately, these contributions grow tax-free instead of tax-deferred. Income tax impact for the individual is potentially significantly minimized. So why doesn’t every plan offer these features and why doesn’t every 401(k) plan participant exercise these options if they are available?

While it is true that the after-tax contributions do not count towards an individual’s annual IRS deferral limit ($20,500 for 2022 or $27,000 for anyone age 50 or older during 2022), the fact is these after-tax contributions are technically treated as EMPLOYER contributions. This subjects them to certain IRS-mandated compliance testing. Most prominent is the non-discrimination test as an employer matching contribution (that’s the ACP or Actual Contribution Percentage test, if you’re interested). What does all this mean? The availability of employee after-tax contributions in a plan may not be as beneficial as some might think. Is it worth exploring? I think so.

Are you interested in saving more for retirement?
 

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