Make the most of your clients’ after-tax retirement plan contributions

By Steven Jarvis

Big numbers and catchy headlines are great conversation starters but often become distractions from what works for most people in practice. Funding “mega back-door Roth contributions up to $61,000 every year!” sounds much more exciting than “let’s make sure you maximize your employee contributions.” However, great advisors know there is value in the basics.

Steps to take BEFORE clients make after-tax 401(k) contributions

Consistent incremental action will always beat a grand plan that never gets implemented. The ultimate goal of making after-tax contributions is to get dollars into the coveted tax-free Roth bucket. If you think a client might be a candidate for making after-tax contributions, make sure you take the following steps.

Step 1. Ask if the client has maximized their Roth 401(k) contributions. There is no income limitation on making Roth contributions within 401(k) accounts, unlike a Roth contribution to a non-401(k) plan account. Roth options within 401(k) plans are becoming widespread, which means most clients can contribute $20,500 ($27,000 for clients over the age of 50) straight to a Roth account within their 401(k) plan in 2022. 

Step 2. If the client has maxed out their funding of the Roth option in their corporate retirement plan, recommend they make back-door Roth contributions. For 2022, that means getting an additional $6,000 ($7,000 for those 50 and over) into a Roth IRA. Not all retirement plans allow for in-plan Roth conversions, so converting into an account separate from a corporate retirement plan creates additional flexibility. This also assumes the client is over the income threshold ($144,000 of modified adjusted gross income for single filers and $214,000 for those married filing jointly) to make Roth contributions directly into a Roth IRA. (See “A mega planning opportunity for high-income clients: the mega backdoor Roth” in the Nov. 2021 NAPFA Advisor.) 

Step 3. If the client is eligible, recommend they maximize their contribution to their health savings account (HSA). Similar to Roth accounts, funds in an HSA grow tax-free and are distributed tax-free once time and age requirements are met. The bonus of an HSA is that the funds go in tax-free as well. For qualifying taxpayers, the contribution limit for 2022 is $3,650 for individual coverage and $7,300 for family coverage, with a $1,000 catch-up per taxpayer over the age of 55. (See “Health savings accounts: planning opportunities and pitfalls” in this issue of NAPFA Advisor.)

Step 4. Look ahead at Roth conversions. For many clients, the time between retiring and then taking Social Security and, ultimately, required minimum distributions can be some of their lowest-income years. This means that it could make more sense to maximize pretax contributions during their high-earning years in anticipation of being able to do Roth conversions in the future, rather than going straight to making after-tax contributions now.

A quick reminder on retirement plan contributions: Employer contributions are always pretax dollars. Even if the employee is making Roth or after-tax retirement contributions, any employer match or profit sharing is considered pretax dollars. This makes sense for the employer because their contribution is an expense they want to deduct for their taxes. However, this can come as a surprise to the employee when they distribute or roll the funds out of the 401(k) plan. In the case of a rollover, the employer contributions can absolutely be rolled into a tax-deferred IRA, but in practice, when an individual receives a Form 1099-R designating part of their rollover funds as “taxable,” it’s often the first time the employee realizes that there are two buckets of money and only one is tax-free.

Next steps

Only after you’ve done everything recommended above, is it time to consider whether after-tax 401(k) contributions are a good fit for a particular client. When you start the conversation with the client, it is essential to remember that every retirement plan is different and you need to understand the specifics of their plan before you tell them the strategy will work.

An advisor can get the plan documents and review the details to see whether the option for after-tax contributions is available. Great advisors provide an email their clients can send to their human resources department requesting the information.

The email could go something like this—and feel free to copy-paste and edit this email for use by your clients:

Dear HR team,

I am working with my financial advisor, Rockstar Advisor, to plan for retirement and would like to understand the options available within our company’s retirement plan. Specifically, I would appreciate information on the ability to make after-tax contributions and the ability to make in-plan conversions to Roth.

Rockstar Advisor offered to schedule a call if there are any questions they can help with or information you would like to relay directly that would make changing my contributions easier.

Thank you for your help.

Tailor this in a way that resonates for you and your clients. Pro tip: There is a high likelihood your client will simply forward the message, so make sure your message to the client is written in a way that you would be excited for the HR department to have that email as their first impression of you.

Why take this extra step? Three key reasons:

1. It is a great way to make sure you are getting current, accurate information about the options available under the retirement plan.
2. After-tax retirement plan contributions are likely not something the HR department sees every day. Letting them know this is being considered can help ensure the strategy is implemented correctly.
3. The client has now introduced you to a center of influence at a company that clearly employs people who fit your ideal client (one of your clients already works there). You have set yourself apart to the HR department and will be in their minds when other employees come asking questions that are beyond their expertise.

After you’ve established the plan allows for after-tax contributions, communication and record-keeping are key. The funds need to start in the right bucket and end with getting the funds converted to Roth. The waters get especially muddy as clients change employers and funds get rolled between plans.

Remember the dishwasher rule

The dishwasher rule, as explained by Micah Shilanski, CFP^®, co-founder of The Perfect RIA, is the idea that you only get credit for doing something if the person you did it for knows you did it. In other words, you only get credit for doing the dishes if your significant other knows you did them. This may sound like trying to pat yourself on the back, but it is a fantastic way to deliver massive value to clients.

After-tax retirement plan contributions likely won’t be a fit for all your clients. However, like other tax planning strategies, the only way to know if it is a good fit is to understand a client’s circumstances and analyze their specific situation. Great advisors apply the dishwasher rule and let their clients know that assessment was done, regardless of the outcome. Now, when articles come across their newsfeed with trendy headlines, the client can feel confident their advisor has considered those solutions for their situation.

Regardless of the tax topic, remember to start with the basics. Focus on helping your clients take action without getting lost in intricate, dark corners of mathematical optimization. And of course, implement the dishwasher rule!

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Steven Jarvis, CPA, is the CEO and head CPA of Retirement Tax Services, a tax preparation and planning firm specializing in collaborating with financial advisors. Steven is an author, nationally recognized speaker, and host of two tax-focused podcasts.

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