When new office employees are starting a new job, they often go through the same routine. The first few days are spent locating the break room, finding a good parking spot, and orienting to the cultural norms. Then there’s the meeting with human resources—you get a key card, complete payroll deduction paperwork, and review compliance documents. Dental insurance? Extra life insurance? How much should the company take out for 401(k) contributions? Pre-tax or after tax? Most people go with the flow. The quickest and easiest answers are the ones first deployed. The price of ease, however, is often missed opportunity.
Employer-sponsored retirement plans come in many different flavors. Contribution and distribution options, investment choices, fees, and tax-deferral opportunities are generally plan specific and vary significantly among employers. Plan administrators must provide its plan participants with detailed documentation for each plan. For most retirement plans, this is in the form of a Summary Plan Description. These documents are often a gold mine for optimization opportunities, so it’s critical to review and understand the provisions within.
With the following two examples, my hope is to illustrate the importance of knowing and understanding the plan documents:
First, we always want to know if a retirement plan allows for participants to roll outside money into the plan. For example, a new employee may have worked at a previous employer and has either a 401(k) tied to the former employer or moved those old 401(k) assets to a rollover IRA. It’s helpful to know if the employee’s new 401(k) will accept those assets. That seems like a small detail, so you might wonder why it would matter at all. Well, let’s assume that the employee is approaching age 70 and still going strong at work. The employee is passionate about the work, doing a great job, and earns a healthy salary. Although the employee’s new 401(k) account will be unaffected when the employee turns 70, any money left in an old 401(k) or rollover IRA will be subject to the required minimum distribution rules, meaning a percentage of those accounts must be distributed and treated as ordinary income for tax purposes. The tax consequences might be quite severe if the employee is still working and earning substantial income. Wouldn’t it be nice if the employee could, instead, move all the old assets into the new plan to avoid those required minimum distributions (and the taxes) while still employed? The Summary Plan Description for the new 401(k) will tell us if it’s possible.
The second example is a strategy that is underutilized, but can save significant tax dollars in the future. Most mid-size or large companies offer the traditional 401(k) option. Some go a step further and also offer a Roth 401(k), wherein employees contribute post-tax dollars to be invested and grow tax- free. In some cases, employers even include plan provisions allowing for “after-tax” contributions to the plan. These contributions are distinct from Roth 401(k) contributions, and the IRS contribution limits for after-tax contributions into a retirement plan are considerably higher than 401(k) contribution limits or Roth IRA limits. In some cases, for example, it’s possible that an employee can put $30,000 per year into the plan as an after-tax contribution. If the plan also offers the flexibility of “in service rollovers,” that same employee can then roll those “after-tax” funds to a Roth IRA account. After the rollover, those funds would then grow tax free within the Roth. While most people are limited to Roth contribution limits of $6,000, our example employee managed to make a $30,000 contribution to a Roth account simply by fully understanding and optimizing the retirement plan provisions.
Advisors at Carlson Capital Management have experience working with all types of retirement plans, and we’re constantly reviewing plan documentation looking for optimization opportunities for our clients. Feel free to connect with your advisor directly if you have any questions about your retirement plan and the related opportunities that may exist.