Sat, 14 Mar 2015
A recent IRS ruling on Roth conversions of aftertax 401(k) money could make the option more appealing for savers who have maxed out their other accounts, says financial-planning expert Michael Kitces.
Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Recent IRS rulings make aftertax 401(k) contributions more attractive than they were in the past. Joining me to discuss if and when aftertax 401(k) contributions make sense is financial-planning expert Michael Kitces.
Michael, thank you so much for being here.
Michael Kitces: It's great to be here. Absolutely.
Benz: Aftertax 401(k)s have been in the news recently. Let's talk about aftertax 401(k)s. First of all, how are they different from Roth 401(k)s, to which people also make aftertax contributions?
Kitces: So, the whole point about aftertax contributions to a Traditional 401(k) is that it is still a Traditional 401(k), which means your growth is tax-deferred as long as the money is in there and your money is still taxable when it comes out. So, it's a crucial difference to recognize. We're not talking about doing Roth contributions, which also happen to be with aftertax dollars but are tax-free. We are talking about going beyond the deductible contributions in a 401(k), adding more on an aftertax basis. So, in other words, you are not getting your deduction upfront and it will still be taxable down the road; you just get this window of tax deferral in the intervening time period.
Benz: So, let's talk about what has changed in the realm of aftertax 401(k)s that makes this potentially a more interesting thing to do for a lot of investors, especially high net worth folks who are maxing out their 401(k)s and IRAs.
Kitces: So, what changes is not just about doing aftertax contributions to 401(k)s, which frankly have never have been terribly popular because you are not really getting the tax deduction going in and everything coming out on the backend is ordinary income. So, maybe if you had no tax shelters at all, you might put some bonds in there that were going to be ordinary income anyway and now they will be ordinary income but tax-deferred. But if you were going to put equities and other things in there, it wasn't terribly appealing--no tax deduction, you are going to convert it all to ordinary income. It wasn't done very much.
What changed over the past 15 years was we introduced Roths and the idea that you can do Roth conversions. And for a long time, people have been trying to do conversions of aftertax 401(k)s. And both the opportunity and the confusion that was out there for a long time is if you put aftertax money into a 401(k). So, let's say we've contributed for years. There's $100,000 in the account, and it includes $15,000 of aftertax contributions we've made over time.
When you took the money out, employers would typically send you two checks. The first one would be $85,000--that's all the pretax contributions and all the growth. The other one would be $15,000--that was the aftertax amount. So, people say, "Well, I got a great idea: Now that we can do all these Roth conversions, why don't I take the $85,000 and put it in a rollover IRA and I will take the $15,000 and I will put it in a Roth?" So, in essence, I'll convert just the $15,000. Since it's a Roth conversion, it's taxable; but since it's all principal, there is no actual taxable amount. You report the amount as zero, and you've changed $15,000 of aftertax contributions in a 401(k) to $15,000 of aftertax contributions of Roth, even if you've already maxed out Roths.
This became more and more popular over the past couple of years, both because with the Pension Protection Act in 2006, we made it possible to do Roth conversions directly from 401(k) plans to Roths--that hadn't existed before--and then in 2010, we got rid of the income limits, so anybody could do this regardless of the income scale.
The problem is, when you actually dig into the tax code itself, it wasn't really intended for the two check rule to be a conversion rule. The code actually said that if you do a conversion, you are really supposed to do all of this pro rata, and there was kind of a weird workaround where you would take the money, hold it for a period of time in your checking account, and roll it over later, or you could sort of do an end run on the rules. But Class C was supposed to be pro rata, which means if $15,000 of the $100,000 is aftertax, only 15% of every check is principal for a conversion and the rest would be taxable and you didn't get a very good Roth conversion treatment.
So, last year was kind of the surprising event. The IRS basically threw in the towel and capitulated and said, "Since there is kind of this workaround to it anyway, we're just going to open this up and make it much easier to do." So, the IRS said simply, "You get a $100,000 check or you get two checks--one for $85,000 and one for $15,000. You don't have to do the pro-rata rule anymore. You can choose wherever you want to allocate the $15,000 of basis and wherever you want to allocate the $85,000 of gains." And, of course, now it's pretty straightforward. You put the basis to the Roth, you make it a tax-free Roth conversion, and you do the rest as a rollover to an IRA. So, they basically blessed what was sort of informally being done and, frankly, sometimes was being done wrong in the past, because people didn't know about the pro-rata rules. [The IRS] just said, "Fine, you can do it going forward--you can do these Roth conversions."
Benz: You put it a really nice way to me: When thinking about these aftertax 401(k) contributions, it's kind of a deferred Roth contribution. I think that is a helpful way of putting it.
Kitces: So, the IRS blessed this. And the first wave that we've seen was simply people who had aftertax money in a 401(k) who said, "Fantastic. Now, I can take all the money out, I can split it up, I can convert the aftertax, I can roll over the rest. I basically just get to put money into a Roth and now it can grow tax-free while my 401(k) was growing merely tax-deferred."
But the second wave that comes right afterward is, "Well, if I can do that with the aftertax funds that are already in there, now I want to contribute even more aftertax money because I know, at some point down the road, I'm going to be able to convert it to a Roth. And between now and when I convert it, that growth is still going to be taxable. But once I get to the conversion point--whenever I separate from service or I'm otherwise allowed to take the money out of the plan--I'll actually be able to convert all the aftertax to a Roth. [For instance,] I put in $10,000 aftertax now and three or five or 10 years down the road, I convert that contribution into a Roth, and so it becomes this deferred Roth contribution. Eventually, I'll get it into the Roth. I just need to wait a while until I can actually do the rollout and the conversion."
Benz: Right. So, the profile for whom this aftertax 401(k) would be most attractive is obviously someone who's kind of stuffing all of the money that they can in their tax-sheltered vehicles.
Kitces: You want to be maxing everything else out first.
Benz: Let's talk about why this would come later in the funding queue.
Kitces: So, the biggest driver to it is just this recognition: Yes, if I put aftertax money into a 401(k), at some point down the road, I can convert it and make it a Roth. But if my alternative is that I could just put money into a Roth 401(k) right now--same tax treatment today, it's aftertax no matter what, but instead of waiting to convert it later into a Roth, it's a Roth today. I get my tax-free growth starting immediately, not taxable for a period of time until I can roll it out later and then eventually get around to doing a Roth conversion on the contribution.
So, we can sort of sequence this out that if I'm going to be doing aftertax already, I really still want to first maximize every aftertax, that's just a Roth on day one. So, I still want to maximize my Roth 401(k) if I have it available; I still want to maximize my Roth IRA while I have it available. Once I've gotten through those categories, recognizing now that we've crossed a number of people out from realistically pursuing this strategy because you can get well over $20,000 into a Roth 401(k) plus a Roth IRA, and that's already more [money] than a lot of people have available to save. But once we get through those, this now becomes appealing as kind of the third tier afterward.
We're done with the Roth contributions in the 401(k); we're done with the Roth contributions in the IRA. I have more money that I want to contribute. I'm trying to figure out where to put it now, and this becomes a new window that's available. I'm going to do aftertax contributions. I'm done with immediate Roths--now I'll do the deferred Roth.
Benz: So, this would come ahead, though, in the funding queue of just putting money in a taxable account, right? There are some important tax advantages here.
Kitces: Generally, it's still more appealing than putting it in a taxable account. You get, at worst, a tax deferral while the money is still in the plan. You know you're eventually going to be able to do a Roth conversion and make that growth tax-free down the road. Realistically, if there's someone who is working now and they might not leave the company for 30 years and you're going to have 30 years' worth of taxable growth before you finally get to the Roth conversion, I can imagine someone might decide that they'd rather just kind do it on the side in a taxable account to get their preferential capital gains, particularly if they have low turnover and they're a buy-and-hold investor.
But realistically, I don't know very many people who are in their 20s and 30s and are making retirement contributions, envisioning that they're going to be at this company for 30 years and that they're going to leave it in the 2040s. Our workforce is a little bit more mobile now. And because every time you have a job change, the 401(k) becomes liquid, if it wasn't already, and you have the opportunity to do the rollover and the conversions, realistically I expect a lot of people are going to find this appealing versus just taxable accounts because it's probably not that far out until they're going to have the opportunity to do their deferred Roth conversion.
Benz: One question I've gotten on this topic is, particularly for people who work for smaller employers, could a lot of people stuffing money into the aftertax 401(k)s lead the plan to run afoul of some of the nondiscrimination policies in place? Without getting too far into the weeds about what those are, is that a risk?
Kitces: Yeah, it is a risk. First and foremost, just for anybody who's listening who wants to do aftertax contributions to their 401(k), your plan has to allow this. It's not an automatic thing. Just because you have a 401(k) doesn't mean the plan will also allow aftertax contributions above and beyond the initial 401(k) limits. So, caveat number one is that the plan has to allow it.
We see a number of large firms that do, a number of small firms generally don't. But often, in small businesses, since it's their business, they control it and they want to add it in. Now, the caveat that comes up, as you've alluded to, is that there are rules for 401(k) plans that limit essentially how much the highly compensated folks put in relative to everybody else. Now, when you get a really large corporate environment, these rules rarely become an issue. There are so many people involved that the numbers tend to average out.
When you're a small business and there are eight of you--two owners and six employees--and the owners are highly compensated and the other six are not and the owners max it out and the lower-income employees, often who are younger, don't have as much to save and don't contribute as much, you potentially run afoul of these rules and create some problem.
So, at a minimum, if someone is looking at this in a small-business environment or wants to add it to their plan in a small-business environment, they need to talk to their qualified plan consultants about whether they can actually do this, given the kinds of dollars that they put in, and not run afoul of the rules.
Kitces: The other thing, actually, that I'd note for small businesses as well: There are sort of three different ways that money ultimately gets into a qualified plan, in general. We can put in 401(k) contributions, we can put in profit-sharing contributions from the company, and we can try to put in aftertax contributions as well.
For a lot of businesses, particularly in small businesses, just the first two categories--their salary deferrals for 401(k)s and their profit-sharing--actually maxes out the entire plan. So, there's a limit to how much a person can have in all dollars from all sources going into a qualified plan. It's about $53,000 a year; it gets adjusted each year for inflation. So, actually, we also see that a lot of small businesses don't actually need to go down this road. It's not going to help them because they're already hitting the limits just with their profit-sharing contributions and their 401(k) salary deferrals.
But if you have a gap, if you're not otherwise maxing it out, this becomes an opportunity. And in a lot of large-firm environments, they are often not maxing it out and this becomes an opportunity.
Benz: Another big question mark lurking out there is whether this idea of making aftertax contributions could face some legislative risk. Could Congress look at this and say, "This is a loophole for affluent people--maybe something we want to shut the door on."
Kitces: There is legislative risk to this, and it's actually now been acknowledged in Washington. So, President Obama's budget that came out this year actually had, for the first time, basically the proverbial loophole closer that would unequivocally shut this down. It would actually shut this down as well as the infamous backdoor Roth contribution where you do nondeductible contributions to an IRA and convert it. And the wording in the rule is very straightforward. It simply says that if you have aftertax money in an IRA or a 401(k), you can't convert the aftertax portion--and that would be that.
So, there is legislative risk to this, particularly recognizing that with something like aftertax contributions to a 401(k), you really do legitimately have the possibility that you will still be working for the company and not be able to roll the money out, and they will change the rule in 2017, and you don't even have a workaround. There is just no solution. You're going to find the aftertax contributions you made that you thought you were going to convert down the road are just going to remain aftertax contributions in a 401(k) forever.
Benz: So, you still get the tax-deferred compounding--
Kitces: You still get the tax-deferred compounding. It's not the worst thing in the world. So, you're not necessarily damaged and worse off, but you may not get quite the benefit that you were expecting out of it. And the fact that Congress clearly now has this on the radar screen means that, realistically, I do think there is some danger to this. It really is perceived as a loophole, not least of all because, in the IRA context, the strategy has literally been dubbed the "backdoor" Roth contribution. You couldn't put a worse label on it to call it tax abuse if you wanted to.
So, I do think there is a perception from Congress that this is a form of loophole abuse and that they may shut it down. And in particular, since it's relatively easy to do so in a tax context, you simply say there's no such thing as conversions of aftertax IRAs and 401(k)s anymore--and that would be that. So, at least be cognizant that it's out there as a risk. If you're going to start pursuing this strategy with a hope of doing a deferred Roth contribution down the road, recognize that that conversion opportunity might not actually be there when the time comes.
Benz: Michael, always great to hear your insights. Thank you so much for being here.
Kitces: Absolutely. My pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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