Will a tax incentive motivate you to save more? The reality for most is a resounding, YES. If this sounds like you, you may be interested to learn about a new rule regarding after-tax contributions that may affect your 401(k) Plan in 2015.
A recent ruling by the IRS may give many small business owners and high wage earners incentive to contribute more to 401(k) plans. Beginning in 2015, eligible employees will be allowed to shift after-tax 401(k) contributions directly to a Roth IRA upon separation from service. For individuals who can easily exceed 401(k) pretax contribution limits or income limits for Roth IRA contributions, this means there is a new option for additional retirement savings and the potential for substantial tax savings during retirement.
The Roth IRA Advantage
In 2015, couples earning $193,000 or more and individuals earning $131,000 or more are not eligible to directly contribute to a Roth IRA. For couples and individuals whose earnings are under these thresholds, contributions up to $5,500 (plus $1,000 “catch up” if 50 or older) per year are allowed. The advantages of a Roth IRA are numerous. Unlike a traditional IRA, minimum distributions at 70 ½ are not required. Because contributions to a Roth IRA are made with after-tax dollars, distributions from a Roth IRA (subject to holding rules), are tax free and do not increase adjusted gross income. Since distributions do not increase adjusted gross income, this can also help lower Medicare premiums or the 3.8% surtax on net investment income.
Contributions made to company sponsored 401(k) plans are typically made with pretax money thereby lowering the taxable income of the employee. While contributions and subsequent growth within the account is tax deferred, a withdrawal of this money in retirement is taxed as ordinary income. At current tax rates, this could be as high as 39.6%. Distributions can be deferred until 70 ½ but must be taken annually until death after reaching this age threshold. Maximum pretax contributions in 2014 are $17,500 plus an additional $5,500 “catch up” if 50 years of age or older for a total of $23,000. These limits will rise to $18,000 and $24,000 ($6,000 catch up), respectively in 2015.
The New Policy’s Difference for High Earners
The fact that individuals can contribute after-tax dollars to their 401(k) plans is not new. What’s changed in this ruling is that you can now (upon retirement or separation from service) easily direct pre-tax dollars to one destination (Rollover IRA) and after-tax dollars to another destination (Roth IRA), all within one distribution request. What was once a very convoluted process to try and separate pre-tax from post-tax, has now been addressed and greatly simplified by the IRS with this ruling.
While the maximum salary deferral to a typical 401(k) in 2015 is $18,000 plus a catch-up of $6,000 if you are over 50, some plans allow after-tax contributions in excess of this amount. For high wage earners seeking maximum savings, those with eligible plans may be able to defer up to $54,000, plus a catch up of $6,000. That’s a potential savings of $60,000, which includes pretax contributions, pretax employer matches, and after-tax contributions. To take advantage of the new rule, contributions up to the maximum pretax amount must be made first and the plan must also allow after-tax contributions.1 High wage earners or small business owners looking to save more and shelter additional income may want to consider this strategy in order to have after-tax money eligible for a Roth conversion in retirement.2
If you’d like to learn more, talk with one of our advisors today.
- Not all employer plans allow after-tax contributions. Refer to your plan sponsor’s benefit booklet for details regarding your company specific retirement plan.
- Keep in mind, although the after-tax contributions can move to a Roth IRA at retirement without tax consequence, the earnings on those after-tax contributions would still be subject to taxation, either at rollover to a Roth or ultimately at distribution if in a Traditional IRA.