With the annual review of their 401(k) plan always just around the corner, plan sponsors should think through any changes they may need to make to ensure the plan remain compliant with ERISA. But while undertaking such due diligence, don’t forget to also think through ways to improve the plan.
There are three plan provisions that are often overlooked but can provide great value to a 401(k) plan:
- Roth contributions
- Employee after-tax contributions
- In-plan Roth conversions
While Roth contributions are not a new new feature, more retirement planners are recognizing the tax-diversification benefits that Roth contributions bring to the table. And new rules have made employee after-tax contributions and in-plan Roth conversions increasingly desirable to employees.
While your plan might not need all three of these features, you should at least take the time to review them and balance the benefits of each against its cost and administrative burden.
Since 2006, employers have been able to amend existing 401(k) plan documents to allow employees to elect Roth tax treatment for a portion or all of their employee 401(k) plan contributions. Employees have the choice of contributing to the Roth account or doing a traditional pre-tax elective salary deferral into the plan.
Additionally, the employer can continue to make matching contributions on the employees’ Roth and traditional contributions. However, the match does not receive the Roth tax treatment. Employees make their contributions on an after-tax basis and will not reduce their adjusted gross income (AGI) for the year, but the growth on the Roth contribution investments can be withdrawn tax free if the employee satisfies certain holding period and trigger requirements.
Allowing Roth contributions to a 401(k) plan is very beneficial for employees that need tax diversification in retirement, are concerned about rising tax rates, or currently pay low income taxes. In fact, there are certain employees that should set up a Roth IRA and not make additional contributions to a 401(k) after they have contributed enough to receive the employer-provided match.
The addition of the Roth account in their 401(k) can improve participants’ retirement, allow them to save more money, and reduce their need to set up other retirement savings accounts outside of the 401(k) plan.
Not to be confused with Roth contributions, the ability to make after-tax contributions can really jack up some participants’ savings. While an employee can defer up to $18,000 pre-tax into a 401(k) plan annually, even those employed by plan-sponsoring organizations that offer a 100% match will fall $17,000 short of the $53,000 annual limit for contributions.
The after-tax contributions are not deductible from an employee’s AGI. They also do not receive tax-free growth, as Roth accounts do. However, the savings does receive the same tax-deferred growth that other 401(k) assets do, as well as the same creditor protections.
IRS guidance Notice 2014-54, issued in 2014, has made employee after-tax contributions even more favorable. The employee, upon termination of employment, can now roll over portions of a distribution to multiple destinations and have them treated as a single distribution. Thus the employee can roll over tax-deferred amounts to a traditional IRA or new 401(k) plan, and after-tax contributions to an IRA. That will result in far more wealth accumulation and at retirement will allow the plan participant to take full advantage of Roth IRA benefits for the after-tax contributions.
In-Plan Roth Conversions
These conversions, also referred to as in-plan Roth rollovers, allow employees to convert tax-deferred accounts to a Roth account, providing more control over tax planning for their 401(k) assets. While it might have been a good idea at the time to take a pre-tax salary deferral into the 401(k) plan, an employee’s situation may change. He or she might decide it would be better to convert some of that to a Roth account, pay ordinary income taxes on the taxable portion, and receive the tax-free growth going forward.
Not many plans offer this feature currently, but more have added it in 2016 because of increased awareness about the importance of flexibility and tax diversification in retirement income planning.
The lack of retirement savings is a crisis that is only getting worse as the population ages. Studies show that Americans’ greatest financial regret is not saving enough for retirement. People who reach retirement age with insufficient savings generally have only two options: work longer, or accept a lower standard of living in retirement. And that first option is often available, because many people are forced to retire early due to concerns about their health or the need to care for a loved one.
That’s a key reason whey plan sponsors should consider helping workers maximize their retirement plans by incorporating Roth contributions, employee after-tax contributions, and in-plan Roth conversions.
Jamie Hopkins is an associate professor of taxation and co-director of the New York Life Center for Retirement Income at The American College of Financial Services. Robert Johnson is president and CEO of the college.