Retirement Meditation #8: What’s the fuss with employee after-tax contributions?

Insights | Retirement Meditation #8: What’s the fuss with employee after-tax contributions?

Author: Paul A. Carl, CHSA, CPFAVice 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?

The content of this blog is offered by HORAN Wealth Management, an SEC registered investment advisor. This information is not intended serve as legal advice or as a substitute for the advice of your own counsel and should not be relied upon as such, as the advice appropriate for you will be dependent upon the particular facts and circumstances of your situation. We provide links to other sites that we believe may be useful or informative. Any links to third-party sites, or information therein, are not intended as and should not be interpreted by you as constituting or implying our endorsement, sponsorship, or recommendation of the third-party information, products, or services found there. Neither the information nor any opinion expressed constitutes a solicitation to use our services or to purchase or sale of any security. Any reference to past performance is not to be implied or construed as a guarantee of future results. Market conditions can vary widely over time and there is always the potential of losing money when investing in securities. HORAN and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended to provide and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.