Many companies offer the common 401(k) retirement to their employees, including the owners. Oftentimes, owners and their employees are unaware of additional planning strategies that are available to them that could improve their personal tax situations.
The Basics
The traditional 401(k) retirement plan allows an employee to make pre-tax contributions up to certain limits. The annual contribution is capped at $20,500 in 2022 (those 50 and older can contribute an additional $6,500 in catch-up dollars). The employer might match a percentage of your contribution to increase the savings. Some plans also provide a Roth 401(k) option, which allows for an employee to make after-tax contributions to the plan.
The key difference between pre-tax and after-tax contributions is the tax impact. Pre-tax monies generate an up-front tax deduction for the employee, with the retirement distributions ultimately being subject to income tax. After-tax, or Roth, contributions are made with post-tax monies and the distributions in retirement are not subject to tax.
What if an employee, including a business owner, could enhance their retirement savings above the limits discussed above all while accomplishing a viable short-term and long-term tax planning strategy? This is where after-tax 401(k) contributions could provide an opportunity.
Planning Enhancement with After-Tax 401(k) Contributions
It may come as a surprise to some, but the actual maximum amount within the IRS guidelines that an employee can contribute to a 401(k) plan in 2022 is $61,000, or $67,500 for those over 50. This includes employee and employer contributions.
As we learned from the above, the annual contribution for an employee under 50 is capped at $20,500. If an employer makes a match or profit-sharing contribution of $8,500, this allows for an additional contribution of $32,000 to be made by the employee before hitting the limit of $61,000.
This gap can be filled if the employer’s plan allows for after-tax 401(k) contributions. In this case, the employee can use additional funds to contribute to the plan and obtain the maximum retirement contribution for 2022. Further, if the employer’s plan allows for in-plan Roth conversions, the employee could make after-tax 401(k) contributions and convert those to a Roth account. This creates an environment where the employee accomplished a Roth conversion without being concerned about income limits or taxability of the conversion (assuming no earnings on the after-tax 401(k) contributions). The Roth now allows for the account to grow tax free and ultimately have the distributions be made tax free.
It’s important to note that the above strategy does not consider several factors such as how an employer’s retirement plan is organized and what it allows. It also does not consider the impact of state income taxes, required minimum distributions, an employee’s current and future income tax rates, or potential changes in tax law. All considerations should be evaluated before utilizing this retirement and tax planning strategy.
Brian D. Kitchen is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email.
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