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“After-Tax Fund” Conversions: Act Fast Before the Opportunity Vanishes

Ryan Furtwangler, CFP®   /   Rod Diaz, CRPS®, AIFA®

11/24/2021

So-called “qualified” retirement plans, like 401(k)s, allow you to defer money into a pretax account, a traditional IRA, or a tax-free Roth IRA account. That, of course, is pretty much old news. Even older news, if not as well publicized, is that individuals who have worked at the same company for many years might have had an additional funding option, known by many names but most commonly “after-tax funds.”

Why an “after-tax fund”?
Employees choose to contribute to these funds first and foremost because they allow them to defer money above and beyond the annual salary deferral limits. Currently the limits are $19,500 per year and $26,000 per year for ages 50 and over. Total contributions, inclusive of all sources, can be made in amounts up to $58,000—$64,500 for someone over 50. While the limits were far different in the days these “after-tax funds” were added into plans, the principle was the same as it remains: an opportunity for substantial savings beyond the annual salary deferral limits.

If you have an “after-tax fund,” you cannot deduct contributions for tax purposes, but the savings grow on a tax-deferred basis. As well, you can make withdrawals after age 59.5 without taxes or penalties. Growth is subject to income tax, and possibly a 10 percent penalty, when withdrawn before age 59.5, much like your 401(k).

These funds are not incredibly common, most often found in older employees’ older plans implemented when contributions limits were lower, including some plans that limited contributions to a pretax account to 10 percent of salary. Today’s higher contribution limits, and often the opportunity to defer as much of your income as you want up to the annual deferral limits, have eliminated this option for most plans.

Time to act is now.
While we no longer include the “after-tax funds” option in today’s plans, those who have these balances can convert them to Roth IRAs. But the time to act is now. New rules (Section 138311 of the proposed Build Back Better legislation), while not eliminating after-tax contributions, does limit the ability to convert these balances to Roth IRAs.

Conversion may be advantageous, as when you convert the after-tax balance to a Roth IRA no taxes are due on your contributions. You will owe taxes on the growth. However, you can separate the growth from your contributed sums and roll the growth into a pre-tax IRA as you convert the contributions to the Roth. There is a caveat: you can’t distribute one part or the other, that is, the contributions or the growth; you must distribute the entire amount. Another consideration: most retirement plan recordkeeping systems can’t handle both Roth 401(k) contributions and “after-tax fund” contributions, so you have to take the full distribution with two separate checks then split the funds between the respective IRAs. Also, if you decide to distribute the growth and not roll it into an IRA, that would trigger a tax (which you would be advised to pay with non-retirement plan funds to fully optimize your invested savings). As noted however, it may be more ideal to roll that growth into the IRA and defer the tax.

Be aware that there is an aging rule requiring you to wait at least five years after your first Roth contribution, or the year the conversion took place, to make withdrawals. It is a calendar year rule, so if you converted in November you would have satisfied one of the five years by December 31.

The opportunity to convert an after-tax fund is time sensitive. The new rule would take effect January 1, 2022, and there has been little pushback on the proposal to eliminate the “after-tax funds” conversion provision, likely due to the small number of individuals the rule change would impact.

One final note: If you are an employer thinking of implementing an “after-tax fund” with a retirement plan, know that in today’s world of retirement vehicles, this is not a likely option. There are various testing rules that have to be met for retirement plans, and they severely limit these funds as a strategy for “super funding” through contributions and conversion. “After-tax fund” strategies mostly pertain to employees that already have these balances.

IMPORTANT DISCLOSURES

The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.

Any investment involves some degree of risk, and different types of investments involve varying degrees of risk, including loss of principal. It should not be assumed that future performance of any specific investment, strategy or allocation (including those recommended by HBKS® Wealth Advisors) will be profitable or equal the corresponding indicated or intended results or performance level(s). Past performance of any security, indices, strategy or allocation may not be indicative of future results.

The historical and current information as to rules, laws, guidelines or benefits contained in this document is a summary of information obtained from or prepared by other sources. It has not been independently verified, but was obtained from sources believed to be reliable. HBKS® Wealth Advisors does not guarantee the accuracy of this information and does not assume liability for any errors in information obtained from or prepared by these other sources.

HBKS® Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.


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