Did you know that the modern day 401(k) plan was not invented by Congress, or even any politician at all? In fact, the 401(k) didn’t even exist before about 1980, and it wasn’t some grand government scheme to replace the traditional pension plan that led to their creation. It happened almost by accident, when a creative benefits consultant named Ted Benna read the rules of section 401 of the IRS code, and crafted an employee benefits plan around it.
The rest is history, as they say, and now about 90% of employees at major U.S. employers are eligible to participate in a 401(k) plan, whereas only about 2% of private-sector workers have only a pension plan.
But just because 401(k) plans are nearly ubiquitous doesn’t mean they are all the same. The rules governing 401(k) plans have evolved and developed tremendously over the years. As new 401(k) features arise, we keep an attentive eye out for the best planning opportunities that can appear in the process. And when they do, we want to help clients take advantage of these little-known retirement plan benefits while simultaneously staying in the “good graces” of the IRS.
While 401(k) plans vary widely, and some are poor vehicles for savers due to high fees and poor investment choices, there are also a few plans that go far beyond the others in quality. Very few employees know about these features, but the truth is that taking advantage of them can supercharge your retirement savings.
So, here’s the question — does your 401(k) plan offer these benefits? Is it a “Super(k)”?
What Makes a 401(k) Plan “Super”?
Because of the wide variety of 401(k) plan designs out there, we have identified several key features that have converted a select few plans into what I call “super 401(k) plans.” These plans allow workers to contribute more money, invest more flexibly, and withdraw those funds with more tax advantages than “ordinary” 401(k) plans. But before going on, please note that the purpose of this article is simply to introduce these topics, not to exhaustively examine the details. We highly recommend working with a fee-only Certified Financial Planner professional (one who acts as a fiduciary and in the role of your Personal CFO), as well as the appropriate tax and other professionals, as needed. (In other words, we recommend you call us!)
Bonus Features of a Great 401k Plan
- After-Tax Contributions to Roth IRA Rollovers
- In-Service Withdrawals
- Self-Directed Brokerage Windows
After-Tax Contributions to Roth IRA Rollovers
Due to recent clarifying interpretations from the IRS on a longstanding murky area of the tax code, employees can now save money on an after-tax basis into their 401(k) plan, and later roll those funds into a Roth IRA at retirement. This means that in addition to the $18,000 (2017’s IRS limit) of salary deferral (whether that goes into the pre-tax “bucket” or the Roth “bucket”), some plans also allow an additional amount to go into the plan “after-tax.” On the surface, that doesn’t seem so attractive, because any investment gains on the after-tax contributions will eventually be taxed at ordinary income rates, instead of capital gains rates, which currently are much lower.
However, the ability to roll over those funds into a Roth IRA at retirement means that the gains will actually never be taxed! For most aggressive savers, this is particularly attractive because they are often higher income earners and therefore excluded from funding a Roth IRA to begin with. There are many more details to this strategy, which you can find in my recent article called The Great Tax Escape: Using After-Tax 401(k) Contributions to Fund a Roth IRA.
One of the central ideas behind the 401(k) is tax-deferral — or, earnings on your money inside the account are not taxed; at least, not until they are withdrawn. To “compensate” the government for that lost revenue, the IRS wants to ensure these plans are indeed used for what they are designed — retirement. So, to encourage folks to contribute, but not withdraw their funds until they are “retirement age,” the government penalizes any withdrawal taken before age 59 1/2. (Only the government would use 1/2 year increments for rules, but I digress…)
Typically, the only way you can withdrawal funds from your 401(k) before age 59 1/2 is if you leave employment, and even then you are still penalized for taking a withdrawal, unless you roll the funds into an IRA or an exception applies. Given that most people are in a higher tax bracket while working than in retirement, the penalty plus tax hit can really do damage to your retirement.
However, some funds offer a unique feature called an “in-service withdrawal,” which (as the name implies) allows you to take withdrawals before age 59 1/2. The early withdrawal penalty still applies if you take the cash, but provided you rollover the funds into an IRA, no tax hit is incurred.
Why would you want to do this? Some 401(k) plans have notoriously high fees and poor investment choices, which counteract the benefits you otherwise receive. So, an in-service withdrawal can allow you to move your assets from the 401(k) environment to access better investment choices elsewhere, while still participating in the tax deferral benefits and even continuing to contribute from your paycheck to maximize the tax deductions available.
Self-Directed Brokerage Windows
Company retirement plans (i.e. 401(k) plans) hold your money and are required by law to act as a fiduciary on your behalf. (A fiduciary is just a fancy legal word for someone legally bound to operate with your best interests in mind.) However, companies have been known to neglect their fiduciary duties from time to time, and 401(k)s are no different. One duty in particular that they have is to provide a slate of reasonably diversified investment choices. Sometimes this results only in a menu of expensive funds provided by the CEO’s best friend, or the like. So, as lawsuits have come down on them, plan sponsors have reacted with a little-known option that appears more and more in large company plans: self-directed brokerage accounts.
So, what is that? A self-directed brokerage account window within a 401(k) is a sub-account that allows you to buy any investment option that you would normally be able to buy in an IRA at the typical online brokerage house. For example, most mutual funds, stocks, bonds, and ETFs available at Schwab, Fidelity, or TD Ameritrade in a regular IRA would also be available in a 401(k) self-directed brokerage account.
These are just a few of the potentially helpful features of some 401(k) plans. So how does your plan stack up? While it may be true for some things that “what you don’t know, can’t hurt you,” in this case knowing the intricacies of your workplace retirement plan can really help out your wallet. Not sure where to start? Consider hiring someone who knows the ins-and-outs of these plans, as well as how they best fit into your overall financial situation. A Personal CFO can help you put all the pieces in the right place, and give you peace of mind that your right on track towards your goals.