Many employees, even those nearing retirement, are not fully aware of all the provisions offered in their 401(k) plan. Perhaps the most frequently overlooked attribute is the ability to make additional after-tax contributions to the plan, beyond the employer match.
I have written about this subject before, but in the age of Covid-19 and compressed corporate earnings, it has become even more relevant. Many large companies, ExxonMobil included, have recently suspended matching contributions to their savings plan. But for you, this does not necessarily have to lead to less deferred retirement savings.
Many plan participants believe the maximum contribution an individual can make to their 401(k) plan is $19,500, but this is only partially correct. That $19,500 figure is the maximum contribution most employees can make on a pretax basis and, if the plan offers it, $19,500 is the maximum contribution an employee can make to their Roth 401(k). However, the total allowable contribution to a 401(k) plan in 2020 is $57,000 for those under 50 years of age and $63,500 for those over 50.
How is that possible? Here’s how it works: 401(k) plans can be broken down into three component parts. The first is the pre-tax or Roth portion. For plan participants under 50, $19,500 is the maximum contribution. But for those over 50, there’s also a $6,500 catch-up provision that allows for a total contribution of $26,000.
In addition, there’s another $37,500.00 of potential funds that can be contributed to the plan. Where does this $37,500 comes from? If your employer makes matching contributions, $37,500 is the maximum they could contribute. If your employer contributes less than $37,500 and your plan allows for after-tax contributions, you can make additional contributions to bring the total up to $37,500.
The tax status of the additional $37,500 will depend on the matching provision offered by your employer. If your employer has suspended matching contributions, the $37,500 would be comprised of only after-tax contributions.
This provision will be most useful to highly compensated employees who are already approaching the pretax contribution limit. If your employer has suspended matching contributions, making additional after-tax contributions can keep your retirement savings rate on track.
How do after-tax contributions function within the plan?
The IRS treats earnings on after-tax contributions to 401(k) plans as tax deferred. This means that all growth, dividends, and interest generated by these funds will not be taxable as long as they remain in the plan. At retirement, the IRS will deem all earnings and growth as pretax. If you wish to remove your assets from the plan at retirement, the IRS has special rules regarding after-tax contributions and does not allow for a partial rollover of after-tax funds. You must roll over all principal and earnings at the same time.
The IRS does allow for two rollovers. The principal portion can be rolled into a Roth IRA, while the earnings portion can be rolled into a Traditional IRA along with any other pretax dollars in the plan. This rule does not violate the “one rollover per year” rule, since it will be deemed a single rollover.
Not all 401(k) plans offer this provision to plan participants, and the IRS cannot compel your plan administrator to utilize this tool. Call your plan provider to find out if they allow for after-tax contributions.
It goes without saying that this manner of saving for retirement is far less desirable than getting a match from your employer. But it’s important to know that losing the employer match, for those who are highly compensated, does not have to significantly alter your retirement savings rate. For more information, call your plan administrator for the details.
**This is piece is not intended to advise on the use of IRA Rollovers**
Robert W. Baird & Co. Incorporated does not offer tax or legal advice, but our Financial Advisors regularly work with clients' attorneys and tax professionals to help ensure that all phases of wealth management are addressed.