Know Your 401(k) Plan's Restrictions

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Your 401(k) plan documents may not make for light reading, but they are worth getting to know. Joining me to share what to look for in your plan documents is retirement expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be here. Thanks, Christine.

Benz: Ed, let's talk about 401(k) plan documents. For one thing, there are the tax laws that govern 401(k)s. And then your 401(k) plan may have its own set of operating principles. Why would there be a disconnect?

Slott: Many people don't realize that. I always use the saying when I talk to even financial advisors, I always say, the law of the plan is the law of the land. Even though--and this is strange in the code--one of the most complicated areas of the tax code-- taxes on retirement plan options or distributions--the actual tax code is a lot more liberal than what most plans allow. So, the tax code allows everything that's in the tax code, but plans don't have to. And that surprises people when they go in for certain benefits from the plan.

Benz: So, let's discuss some of these things that can vary based on employers. One relates to presumably a pretty small segment of the population. But people who are older than age 70 and a half and they are still working, they may be able to contribute to that plan. Let's talk about that.

Slott: Yes. And it's not that uncommon anymore, people working past 70 and a half in their plan. So, normally, once you hit 70 and a half, you are subject to required minimum distributions. But there's a special rule in the tax code that says if you are not more than a 5% owner, in other words, if it's not your own business, you can't do it if you're self-employed because you probably own way more than 5%--probably own 100%. So, if you are basically an employee in a company, there's a special rule that says, if you keep working, you can delay or defer required distributions, the beginning date, until April 1 of the year after the year you retire rather than 70 and a half. So, if you retire at age 80, you can delay it for about 10 years. Now, plans don't have to offer this. So you could be subject to required minimum distributions at a plan even though the law says you don't have to take them. This is one, though, that most plans have that provision. So for most people, they will be covered.

Benz: Okay. Let's talk about another one. Loans from 401(k)s. Some plans allow them, some don't. And then there might be different rules about how the loan is treated. Let's talk about some of the considerations there.

Slott: Right. Now, I'm not a big fan of plan loans. I think that should be an absolute last resort. I mean, this is the money you are hoping to get you through retirement. The last thing you want to do is take that money out. And what happens, people that take the money out, they get into trouble financially, they can't repay it and a lot of bad things happen. But not all plans have to allow loans even though the tax code allows plans to have loan provisions. So, that's something you should ask about, because people say, as a last resort, they say, all right, I'm going to take a loan and then they get shocked when their plan says, we don't have that in this plan.

Benz: Okay. One thing you touched on, Ed, was the payback of the 401(k) loan. That's something to keep your eye on, because if you lose that job, oftentimes you have to pay that money back pretty quickly, right?

Slott: It's a taxable distribution, and if you are under 59 and a half, or 55 for certain plans, it's a 10% penalty on top of that.

Benz: Okay. So you want to be really careful there. How about Roth 401(k)s? And I also want to ask about aftertax 401(k) contributions. Let's start with Roth. Some plans offer them, increasingly they do, right?

Slott: Yeah. I think they are coming around. But this is another example, something absolutely permitted by the tax law, but a lot of companies with their plans were slow moving probably because of the history of the Roth 401(k). It was in, it was out, but now it's here, and most companies are coming along. But you may go to a company and say, oh, I want that Roth 401(k), and they say, they don't have it. They don't have to have it.

Benz: Okay. Aftertax 401(k)s, this is something that's really only going to be attractive for higher-income folks who are in a position to set a lot of money aside for retirement. Can you talk about aftertax 401(k)s, why you would want to do this and sort of the tax treatment of those contributions and then the money when it eventually--

Slott: This gets a little confusing, because there's two parts to a plan. We just talked about a Roth 401(k), which is aftertax money. But then there's the regular 401(k) that has pretax and aftertax in that part. What we're talking about is where you can pile up some aftertax money, big money, beyond the regular deferral amount, as you said, if they have the money to do that. And certain plans may allow in-service distributions where you could pull that money out and essentially convert it tax-free to a Roth IRA, big money. But the plans have to allow that provision, the buildup of the aftertax money in the 401(k) side of the plan.

Benz: Okay. And you may also be able to do an in-plan conversion, right? You may be able to contribute aftertax dollars and then convert it to the Roth within the plan?

Slott: Right.

Benz: But this would not typically be something that would be attractive. If you're not already fully funding those basic 401(k) contributions, don't monkey with this, right?

Slott: Right. You have to have the money to do it.

Benz: Okay. Let's talk about rollovers into the plans. So, if I have, say, an IRA somewhere, I start a new employer and really like the plan, some plans allow me to roll other assets in?

Slott: Yes, but not all. Now one strategy many people use--we just talked about that still-working exemption at 70.5--if people are still working and they have IRAs that they have RMDs on, they say, wait a minute, maybe I'll roll my IRA into this plan and then I can delay required minimum distributions. Yes, the tax law allows you to do that. You can't roll an RMD, but you can roll the balance after you took your IRA RMD and then roll the rest if the plan allows rollovers in.

Benz: Okay. And the roll-in can also come into play if I have my eye on doing a backdoor Roth IRA contribution and, say, I have Traditional IRAs that I want to kind of get out of the picture so that it doesn't affect the tax treatment of my…

Slott: Right.

Benz: …so that can be advantageous, too?

Slott: That's an excellent point, because there's a special little-known provision in the tax code that, if you do roll money back from an IRA to a plan, only pretax money is allowed to be rolled back to the plan. And that's a good restriction, because all the pretax money, if you can do it, goes to the plan, leaving, as you just said, the aftertax money. So it gives you more basis, more money that could either be withdrawn or converted to an IRA from your IRA at lower or no tax cost.

Benz: Okay. Let's talk about hardship distributions, how different plans might approach them differently.

Slott: Yes. They don't have to have them. We found this out during many of these hardships that have been coming, the floods, the storms, the wildfires. It seems they are happening all the time. And some people needed to get into their plans for hardship reasons and it's totally allowed by what the IRS and Congress have done after each one of these disasters, and there's been a few cases already where people said, I need this money and the plan, oh, we don't have those provisions, and that's awful.

Benz: That is awful. Ed, thank you so much for being here to summarize. It seems like the takeaway is, read the fine print closely. Your plan may be different than another place where you've worked.

Slott: The law of the plan is the law of the land even though the tax code may allow even more.

Benz: Okay. Good advice as always. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.