Are Super Powers Lurking in Your Retirement Savings Plan?

Retirement savings accounts, such as 401(k)’s, 403(b)’s and 457’s have long been the primary savings vehicles for individuals in the United States. In this country, the burden is on each person to save for retirement if a lifestyle beyond what our social security provides is desired. What if you could help your clients unlock hidden opportunities within their retirement plans that could not only boost the amount saved but also the amount saved on taxes in the future?

Avoid this Common Mistake when Funding Retirement Accounts

First, determine whether your clients are taking full advantage of their company’s match. Is your client making regular contributions that last throughout the full calendar year? If not, they might not be getting their full match. For example, let’s say Lisa, age 40, contributes 25% to her 401(k) and her company matches 100% of that contribution up to 6% of her total income. If Lisa earns $125,000 per year, she will reach her maximum contribution by September at $22,500. But once her contributions stop going into the plan, so do the company contributions. Lisa is much better off contributing 18% of her paycheck the full calendar year so that her company contributes the full year instead of only ¾ of the year.

True Up Match

The only exception to this would be if the company does what is called a True Up Match. The True Up Match catches up employees’ contributions the year following the missed contributions. While this is nice, it isn’t ideal because the preference would be to dollar cost average into the market and have the company match those contributions earlier in the year rather than catch up later.

Don’t forget to readjust contributions at the beginning of each year based on the participant’s goals, income, and yearly limits.

What About those Retirement Account Super Powers?

There is a less known strategy which has been legal since 2014 which allows participants to not only make their regular contributions in retirement accounts, but also allows for additional backdoor contributions into the Roth within retirement accounts. It is called the Mega or Super Roth strategy. This strategy has nothing to do with the funding of Roth IRA’s, which have separate contribution and income limits, which will not be covered in this article.

What is the Mega or Super Roth?

The Mega or Super Roth is essentially the following:

1.   The participant makes regular contributions to a retirement plan, and their company may match those contributions. These can be done pretax (allowing participants a tax deduction now) or as Roth contributions (allowing participants tax free distributions in the future) if the plan allows.

2.   The participant makes additional AFTER-TAX contributions to the plan. (After-tax contributions to the plan are generally not matched by employers, so maximize Step One first.)

3.   The participant converts the after-tax contributions to a Roth source in the plan or possibly converts to a Roth IRA outside of the plan. More on those strategies later.

Note that not all plans allow for Roth contributions, after tax contributions or even conversions from after tax to Roth. To determine if this strategy is possible, it will be necessary to find out what the plan rules are. Plan rules change from year to year, so it might be worth checking back periodically.

Plan Rules in Retirement Accounts

Asking the right questions can help determine what a plan will and will not allow. The best resource is typically the retirement plan administrator.

Plan Limits for 2023

In most cases, participants are allowed to contribute up to $22,500 if they are under the age of 50 by December 31st of 2023, or up to $30,000 if they are age 50 or older by December 31st of 2023. There is another limit which specifies the amount of total contributions between employer and employee that are allowed, and this limit is $66,000 for those under age 50 by December 31st of 2023. There is an additional catch-up contribution of $7,500 allowed if the participant reaches age 50 by December 31st of 2023.

Who Benefits from a Mega or Super Roth?
Participants who are most likely to use the Mega/Super Roth strategy fall into three categories:

Super Savers - These are the clients who have savings in their blood. They are always looking for ways to optimize their savings and the Mega/Super Roth is a great way to do it, especially since regular Roth IRA contribution limits are set at $6,500 per year (beginning 2023), plus a catch up contribution of $1,000 per year for those age 50+ by December 31st.
Empty Nesters - These parents have done their duty, sent the kids off to college and their children have successfully launched into adulthood. They are ready to kick their savings into a higher gear and sprint to retirement.
High Income Earners - High earners can’t put away as much money as a percentage of their income as lower income earners. Executives, doctors, lawyers, and other high earners can use the Mega/Super Roth strategy to shelter more of their income so they can maintain the same standard of living in retirement that they enjoyed while working. Note that all plans must satisfy testing requirements that confirm Highly Compensated Employees (HCE’s) do not disproportionately benefit from retirement plan contributions. Each participant is subject to these rules, and they may end up over contributing to the plan, in which case they will get refunded without any tax penalty. Some high-income earners are not eligible for Roth IRA contributions, so the Mega/Super Roth in their retirement plan may be the only available option if they are not eligible to do a Backdoor Roth IRA contribution.

Real-World Scenarios
Let’s see how this could help people in the above scenarios boost their future tax savings and contribute more to their retirement plans.

John and Terry – Empty Nesters

John, 58, and Terry, 60, are married and would like to retire in five years. They prioritized their children’s needs as they were growing and supported them through college. John and Terry are ready to play catch up with their own retirement and have dreams of traveling and perhaps even owning a condo by the beach where they can winter in the sun. To do this, they have some aggressive savings goals to achieve, and they are ready to commit.

Their combined annual income is $300,000 ($150,000 each), which includes their base pay plus expected bonuses. John’s company allows pretax and Roth 401(k) contributions but does not allow after-tax contributions; therefore, he will not be allowed to do a Mega/Super Roth. John decides to max out his contribution to his 401(k) in pretax dollars. Terry has the option to do the Mega/Super Roth in her 401(k), but the plan will only allow her to do an “in plan” conversion. Here is what their savings could look like this year:

John’s pretax 401(k) contributions ($22,500 + $7,500 catch up) = $30,000.

John’s company will match 100% of his contributions up to 4% of his salary ($150,000 x .04) = $6,000. Between John and his company, the total contributions into his 401(k) will be $36,000, well below the total limit.

Terry is going to max out her pretax contributions just as John did at $30,000 ($22,500 + $7,500 catch up contributions.)

Terry’s company will match 100% of her contributions for the first 4% of her salary and 50% of the next 4% of her salary, meaning that they will match a total of 6% of her income = $9,000.

How much more can Terry contribute to the after-tax bucket and convert to the Roth 401(k) source, which will allow her to max out her contributions? Use this worksheet:

A. Total Contributions Allowed in 2023        $73,500*
    (*$66,000+$7,500 catch up contribution)
B. Terry’s Pretax Contributions:                  $30,000
C. The Company Match:                              $9,000
D. Take line A minus B minus C =               $34,500

For a couple who previously were not allowed to contribute to a Roth IRA because their income exceeded the annual limit of $214,000, $34,500 is a huge sum to be able to put into a Roth for one tax year. Even if they were eligible to contribute to a Roth IRA (based on income), they would cap out at $15,000 in contributions. This is more than double that amount.

Gary and Diane – Super Savers

Gary and Diane met at work and still work for the same firm, are in their early 30’s and they have always aimed to retire early. They are willing to forgo spending now so that they can reach their savings goals earlier. Gary has $155,000 of income per year and Diane earns $110,000 per year. Gary and Diane believe that taxes will rise in the future and last year they put all their 401k contributions into the Roth source within their plan. Because their income was over $214,000 in 2022, they didn’t qualify to make Roth IRA contributions.

In 2023, Gary and Diane work with a financial advisor who runs a financial plan for them, determining that they would be best off, based on the planning assumptions, to put half of their contributions into a Roth source half into a pretax source within their 401(k) plans. Here is the breakdown of how that looks for them:

Gary earns $155,000. His company matches 5% of his income.

A. Total Contributions Allowed in 2023       $66,000
B. Gary’s Contributions:                             $22,500*
   *Gary contributes $11,250 to Roth and $11,250 to pretax
C. The Company Match:                              $7,750
D. Take line A minus B minus C =               $35,750

Gary is allowed to contribute an additional $35,750 to the after tax source in his 401(k) and convert that to the Roth source in his plan.

Diane earns $110,000 per year and the company’s match is 5%.

A. Total Contributions Allowed in 2023       $66,000
B. Diane’s Contributions:                            $22,500*
   *Diane contributes $11,250 to Roth and $11,250 to pretax
C. The Company Match:                              $5,500
D. Take line A minus B minus C =               $38,000

Diane is allowed to contribute an additional $38,000 to the after tax source in his 401(k) and convert that to the Roth source in her plan.

Notice that not only do they have the opportunity to contribute $73,750 into Roth this year, but because they contributed some of their funds pretax, they have lowered their total income threshold to the point that they can also contribute $6,500 each into a Roth IRA if they wish. (Their income is $$155,000+110,000, less the $22,500 they contribute combined to the pretax portion of their 401(k)’s, less their standard deduction for 2023 of $27,700 equals $214,800. The income limit starts at $218,000, so they can make the full Roth IRA contributions, if desired.) Gary and Diane need to continue to make sure they are contributing enough funds to the pretax source to qualify for the Roth IRA in future years.

Drs. Fred and Frankie – High Income Earners

Dr. Fred and Dr Frankie met when they were in residency together. They are heart specialists and are high income earners. Dr. Fred works as a cardiologist for a private practice and earns $300,000 per year. The private practice does an automatic 3% match of his salary regardless of whether he puts money into his 401(k) or not. Dr. Frankie works as a cardiothoracic surgeon for a hospital and contributes to a 403(b) account. She is entitled to a pension and therefore the hospital does not make contributions to her 403(b) account. Dr. Frankie makes $340,000 per year. Both are in their late 50’s and are looking for a way to tax shelter as much money as possible. Based on their savings rate and growth in their investments, they anticipate that their tax bracket will remain high in retirement.

Drs. Fred and Frankie file their taxes jointly and do not qualify for a Roth IRA based on income. They do not have any Traditional IRA’s, so they have been using a backdoor Roth IRA strategy to fund their Roth IRA’s each year and plan to continue to do so.

Dr. Fred’s 401(k) plan allows him to do the Mega/Super Roth strategy in his plan. Here is what his contributions could look like for 2023:

A. Total Contributions Allowed in 2023       $73,500
B. Fred’s Pre-Tax Contributions:                 $30,000*
   *Fred and Frankie decided to make all pretax contributions.
C. The Company Match:                              $9,000
D. Take line A minus B minus C =               $34,500

Fred likes the idea of putting $34,500 additional into the Roth source of his account, but he really likes investing in individual stocks. Fortunately for Fred, his 401(k) plan allows him to do a conversion/rollover into his Roth IRA, which is a brokerage account, where he can trade individual stocks. Always check the plan rules to be sure that there is no penalty when doing the after-tax rollover/conversion.

Dr. Frankie also wants to put in as much as possible into the Mega/Super Roth, and her plan also allows it, so Frankie does the following:

A. Total Contributions Allowed in 2023       $73,500
B. Frankie’s Pre-Tax Contributions:            $30,000
C. The Company Match:                                    $0
D. Take line A minus B minus C =               $43,500

Because Dr. Frankie’s hospital doesn’t offer a match, she can contribute more into the Roth source than her husband. She would prefer to roll this over into a Roth IRA outside of the plan to get more investing options, but that is not available in her 403(b) account.

A few important details about the Mega/Super Roth:

Automatic In-Plan Conversions
Some retirement plans allow automatic in-plan conversions. That means that as soon as money goes into the after-tax source, it is immediately converted to Roth. The benefit of having it automatically converted, if the plan allows, is that there is no growth of those after-tax funds prior to conversion.

If a retirement plan doesn’t allow after-tax contributions to be automatically converted to a Roth, the plan may allow one of two other things:

1.    the participant may be able to pay taxes on the growth in the current calendar year and move it to the Roth source, or

2.   The participant may be able to move the growth to the pretax source and move the after-tax growth to the Roth source, avoiding any additional taxation for the current calendar year. Doing more frequent, or better yet, automatic conversions of the after-tax money will minimize this issue.

Keeping the Roth in your Retirement Plan vs. an IRA
Some people or advisors prefer the investing options of a Roth IRA brokerage account to the limited investments in the retirement plan. In that case, if the plan rules allow, they can convert and roll over the after-tax money instead of leaving it in the plan. Keep in mind any other legal or cost advantages of keeping money in the retirement plan such as federal protection from lawsuits or lower fee mutual funds that would not be available outside of the retirement plan. (Some states protect IRAs from lawsuits, too.)

Separate Designations May Be Available
Some companies have a separate designation for withholding from regular paychecks vs. bonus checks. This can be nice if you are trying to manage a client’s cash flow. For example, if the client doesn’t normally use their bonus money for essential living expenses, they can make a larger contribution of the bonus account into the 401(k) so their goals are met without hampering their cash flow as much.

Do Your Homework
Please refer to this list of important questions to ask your clients’ providers to see if this strategy is an option for your clients or not. Most clients wouldn’t feel comfortable asking the provider all these questions. You would give your client great service by calling the provider, with your client on the line, so that you can ask the questions and record the provider’s answers.

Since plans change their rules from year to year, it wouldn’t hurt to call periodically to see if there are any updates.

Avoid Plan Penalties
Make sure that any conversions of after-tax funds to an outside Roth IRA will not trigger a penalty by the plan. Penalties usually preclude the client from being able to contribute to their plan for a specific period. So not only does the client miss out on their contribution, but they also miss out on matching contributions for that period.

Make Hay While the Sun Shines
If you can afford this strategy and your plan allows for it, the time to start is now. Congress has already attempted to target the elimination of this generous strategy. 

High Income Earners Age 50+ Need to Know This Starting in 2024

Starting in 2024, if you earn more than $145,000 in the prior calendar year, all catch-up contributions at age 50 or older will need to be made to a Roth source of your retirement plan. Individuals earning $145,000 or less, adjusted for inflation going forward, will be exempt from the Roth requirement and can make all their contributions in a pretax source, if desired.

 

Disclaimer: Monica Dwyer, CFP(R), CDFA(R), is a Registered Invesment Advisor Representative with Harvest Financial Advisors in the Cincinnati/West Chester, Ohio area. She may be reached at monica@harvestadvisors.com. This article is for informational purposes only. Any commentary and third-party sources are believed to be reliable but Harvest Financial Advisors cannot guarantee their accuracy.