Are You Maximizing Your 401(k)’s Potential

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Are You Maximizing Your 401(k)’s Potential

by | May 19, 2017

A 401(k) is a retirement savings plan sponsored by an employer that lets workers save and invest a portion of their paycheck before taxes are taken out.  401(k) plans emerged in the 1980’s as a supplement to pensions.  Pensions known as defined benefit plans became more and more expensive for large corporations as the aging demographics required more workers and fund performance to guarantee pension income for retired workers.   But as the cost of running pensions escalated, employers started replacing them with 401(k) plans, a type of defined contribution plan. 

So before, corporations took on the risk of providing a guaranteed benefit to retired workers, the employee now must take on the responsibility of managing their own retirement savings accounts without any guarantees.  With a 401(k), you control how your money is invested. Most plans offer a spread of investment choices which can vary in their performance and risk parameters.  So, the question really is, who is managing probably your most valuable asset?   You may have some knowledge and expertise for deciding the best asset allocation and investment choices but how often are you really looking at the specific investment performance and adjusting the choices based on market conditions, performance, fees etc.?  We offer to assist our clients with regular reviews of their 401k allocations to make sure they’re properly diversified based on pre-determined risk parameters and return objectives.

With that settled, how much should you put in? As much as possible, being mindful that you’ll need to have enough money to live, eat and pay down any debt you may have. At the very least, invest enough to get the full matching amount that your company pays to match your contributions*. You don’t want to leave free contributions on the table. Nearly every plan offers matching funds—the most popular being 3% of your salary, according to the Profit Sharing/401k Council of America**.  If you’re under 50, for 2017, you can defer up to $18,000 of your salary into a 401(k) and if over 50 the plan allows another catch up amount of $6,000.

The annual additions paid to a participant’s account cannot exceed the lesser of:

  1. 100% of the participant’s compensation, or
  2. $54,000 ($60,000 including catch-up contributions) for 2017

That means that even after making the maximum allowed tax-deferred contribution of $18,000, there is still the potential to contribute an additional $36,000 to your 401(k) plan. The IRS actually permits this, with certain restrictions, but relatively few employers offer it.

One of the major restrictions – and the reason that it isn’t more popular – is that the additional contributions beyond $18,000 are not tax deductible. Many taxpayers lose interest in contributing to a retirement plan if there is no deduction for doing so.

Even though you can’t deduct the contributions beyond $18,000, making them on an after-tax basis can still make a lot of sense. Once the additional contributions are added to your 401(k) plan, they can accumulate investment income on a tax deferred basis, just like the funds in any other type of tax-deferred retirement plan.

In addition, contributing the maximum of $54,000 to your 401(k) plan is nearly three times the usual $18,000 limit. That will enable you to accumulate a lot more money before you retire. And, if you’re planning to retire well before turning 65, after-tax contributions should help enable that to happen a lot faster.

There is one caveat, the earnings on after-tax contributions, just like all distributions from pre-tax contributions, are taxed as ordinary income. If the money had been invested in a taxable account, most if not all of the gains would be taxed at the lower rate associated with long-term capital gains. But, there is still another advantage to making after-tax 401(k) contributions.

The Roth IRA Rollover
Since your contributions in excess of $18,000 are made on an after-tax basis, you can convert the non-deductible principal portion of your 401(k) to a Roth IRA…and do so without incurring any income tax liability on the conversion!

According to the IRS, you can roll over your after-tax (principal) contributions to a Roth IRA and the earnings on my after-tax contributions to a traditional IRA?

Earnings associated with after-tax contributions are pretax amounts in your account.  Thus, after-tax contributions can be rolled over to a Roth IRA without also including earnings.  Under Notice 2014-54, you may roll over pretax amounts in a distribution to a traditional IRA and, in that case, the amounts will not be included in income until distributed from the IRA.

Once you roll the funds over to a Roth IRA, you will be converting future withdrawals from tax-deferred to tax-free status.  Imagine if, instead of contributing $5,500 per year to a Roth IRA (the IRA contribution limit), you instead contribute effectively up to $36,000 per year in after-tax 401(k) contributions? Not only will you accumulate a larger nest egg but one that produces income to you on a tax-free basis in retirement. ***
 
* Matching contribution from your employer may be subject to a vesting schedule, please review your retirement plan documents or consult with a financial professional for more information.
** Please be advised not every employer may offer company match contributions at part of their sponsored retirement plan, please review your retirement plan documents for more information.
*** Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. This information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Opinions expressed are those of Thomas Fleishel and are not necessarily those of Raymond James. Investing involves risk, investors may incur a profit or loss regardless of the strategy or strategies employed. Every investor’s situation is unique, you should consider your investment goals, risk tolerance and time horizon before making any investment decision. Prior to making an investment decision, please consult with a financial professional about your individual situation. Be sure to consider all of your available options and the applicable fees and features of each option before moving your retirement assets. While I am familiar with the tax provisions of the issues presented herein, as a Financial Advisors of RJFS I am not qualified to render advice on tax issues, these matters should be discussed with the a tax professional.

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