401(k) After-Tax Accounts

401(k) After-Tax Accounts The forgotten contribution feature 11100 Wayzata Blvd., Suite 360, Minnetonka, MN 55305 952-542-8900 www.360financial.net Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through 360 Financial, a registered investment advisor and separate entity from LPL Financial.

Retirement Decision Points White Paper 401(k) after-tax accounts: The forgotten contribution feature No one can predict the future. Considering the uncertainty of these economic times and what the future may hold for most Americans with respect to tax brackets and deductions, having a potential pool of retirement income with low to no related tax liability could represent a prudent tax diversification strategy. Making employee after-tax to a 401(k) plan is one way to potentially build a source of income in retirement with little tax impact. What are after-tax accounts? After-tax are amounts a plan participant elects to set aside from his or her paycheck after the payroll department withholds taxes. Compare them to pretax employee salary deferrals where the employee sets aside a portion of pay before taxes have been removed. The fi rst employer-plan-based after-tax were made to profi t sharing or money purchase pension-style thrift plans beginning in the late 1950s. The after-tax were generally discretionary if they were being made to profi t sharing plans, but could have been mandatory in the case of money purchase pension plans. As a result of the tax advantages introduced in the Revenue Act of 1978, which included a provision that allowed for the creation of 401(k) plans, traditional thrift plans have all but disappeared, having been replaced with 401(k) plans and the ability to make pretax salary deferrals. Yet 26% of today s 401(k) plans still offer participants the ability to make employee after-tax other than designated Roth. 1 Contributions Depending on the terms of the retirement plan, after-tax may be accounted for separately or be commingled with other non-roth assets. The after-tax conversion strategy works best where the plan accounts for after-tax separately. If the plan accounts for after-tax separately, then any gains or losses in the after-tax account are tracked separately from the gains and losses associated with the participant s other accounts (e.g., salary deferral, matching, rollover, etc). There are limits to the amount of after-tax a participant can make in a 401(k) plan. The law 2 requires plan administrators to consider all after-tax, along with employee salary deferrals and employer, when determining a participant s annual maximum contribution or annual additions limit under IRC Sec. 415(c). These rules currently limit a participant s annual additions for 2014 to 100% of compensation up to $52,000 or $57,500 for those ages 50 and over who are making catch-up ). A participant s after-tax are also included in the actual contribution percentage (ACP) test for the plan, which requires that matching and after-tax in a 401(k) plan do not unduly favor highly compensated employees (HCEs) over non-hces. 2 Finally, after-tax are considered in the top-heavy test for the plan. If a plan is top heavy, meaning more than 60% of its assets are held by key employees (generally, the owners and offi cers of the business), then the plan must meet certain minimum contribution requirements for the non-key employees and vesting guidelines. Even a safe harbor design does not eliminate these testing requirements for after-tax accounts. Distributions Initially, participants could withdraw their employee after-tax tax-free before retirement (i.e., before the benefit became payable as an annuity), which caused lawmakers to be concerned that workers were using these tax-favored arrangements for nonretirement savings purposes. The Tax Reform Act of 1986 implemented revised basis recovery rules that apply to an after-tax account, generally applicable for distributions after December 31, 1986, that provide for the pro-rata recovery of basis for preretirement payments. Under these rules, a participant is entitled to exclude an amount from taxation determined by multiplying the amount of the payment by the ratio of the participant s basis to the total value of the participant s account balance under the plan as of the date of distribution. A special grandfather rule allows participants to fi rst withdraw their pre-1987 after-tax that have been tracked separately on a completely tax-free basis. 3 Calculating the tax-free amount Amount distributed x After-tax 4 = Tax-free amount After-tax account balance 5 If the 401(k) has not tracked the pre-1987 and post-1986 after-tax amounts separately but do track the after-tax separately, the basis recovery rules apply to the entire after-tax account. 1 Retirement Learning Center Plan Document Database, 2013 2 For a plan to pass the ACP test, the ACP of the HCEs cannot be more than 125% of the ACP of the non-hces, or the ACP of the HCEs cannot be more than two percentage points greater than the ACP of the non-hces, and the ACP of the HCEs cannot be more than two times the ACP of the non-hces. 3 IRS Notice 87-13 4 After-tax equal amounts contributed by the employee. 5 After-tax account balance is the sum of after-tax and associated earnings. (1)

In-service withdrawal of 401(k) after-tax account 401(k) plan accounts A closer look at in-service distributions from a 401(k) after-tax account Combined cannot exceed 402(g) limit for 2014 of $17,500 ($23,000 with catch-up age 50 or older).* Traditional salary deferrals > Pretax > Made by employees Qualified Roth > After-tax > No income limits > Made by employees on participation After-tax > After-tax > Not part of the > Made by employees 402(g) limit* Employer > Pretax Total 401(k) by participant and employer cannot exceed $52,000/year ($57,500 with catch-up at age 50 or older) for 2014. Withdrawn without associated earnings When did you contribute? Pre-1987 after-tax All earnings Post-1986 after-tax Withdrawn with a pro rata share of earnings * Internal Revenue Code Section 402(g) Portability: Rolling or converting after-tax accounts If the plan document so permits, it may be possible for a plan participant to request a distribution of 401(k) plan after-tax while still working. As explained previously, the tax consequences typically depend on whether the distribution comes from pre-1987 or post-1986 after-tax amounts. Prior to 2002, employee after-tax in 401(k) plans lacked portability. They were not eligible for rollover to another plan or to an IRA. The Economic Growth and Tax Relief Reconciliation Act of 2001 changed that by allowing employee after-tax to be included in an eligible rollover distribution provided the receiving plan is an IRA or a defi ned contribution plan 6 that separately accounts for the amount. If a participant receives a distribution and wants to roll over a portion of it within 60 days to an IRA, the IRS views the amount rolled over as consisting fi rst of pretax amounts, followed by after-tax amounts. Roth IRA conversions As of 2008, plan participants have been eligible to convert all or a portion of their 401(k) plan balances directly to Roth IRAs, provided they experience a distribution trigger under the terms of the plan (such as having an in-service distribution option or severance of employment). Nearly 81% of all 401(k) plans today offer in-service distributions, which allow participants to withdraw amounts from their plan while they are still working. 7 Of the plans that do offer in-service distributions, many participants may request a distribution of their after-tax account balance at any time. Participants must be aware that a conversion that includes pretax dollars is a taxable event. A participant must include as ordinary income in the year of the conversion the amount of any pretax dollars he or she converts to a Roth IRA. The pretax amounts would be taxable at the participant s current tax rate. Participants must also consider any surrender charges or penalties that may result from the conversion. The year 2010 brought about another change with implications for after-tax accounts: the elimination of income restrictions on Roth conversions. The 2002, 2008 and 2010 changes combined created a new option for affl uent investors looking for ways to acquire Roth assets. An investor s after-tax account in the 401(k) plan may offer a potentially tax-effi cient way to convert and earnings to a Roth IRA if there is a favorable after-tax contribution to earnings ratio. Roth IRAs can offer tax diversification benefits at retirement and legacy planning advantages over traditional IRAs. Investors may want to consider a Roth IRA conversion of their 401(k) after-tax account if they: > Are currently ineligible to contribute to a Roth IRA because of their income level > Contributed after-tax to their workplace retirement plans before 1987 > Have the ability to contribute to their 401(k) plans on an after-tax basis but have not yet done so > Have an in-service distribution option in their plans > Would like to avoid mandatory distributions during their lifetimes with Roth IRAs > Would like to accumulate potentially tax-free assets for their benefi ciaries 8 Since the income limit restrictions for conversion eligibility were eliminated as of January 1, 2010, virtually all investors now have the ability to create a pool of Roth IRA assets through a Roth IRA conversion. After-tax accounts in 401(k) plans potentially can be a tax-effi cient source of convertible assets due to a favorable pretax-toafter-tax ratio. 6 A plan-to-plan rollover must be a direct rollover. 7 Plan Sponsor Council of America, 56th Annual Survey, 2013 8 If the original owner has, or the owner and benefi ciary together have, held the Roth for at least fi ve years. (2)

In-plan Roth conversion Similar to jump-starting a Roth IRA with a relatively low-tax-impact after-tax account conversion, eligible 401(k) plan participants could consider jump-starting or front-loading their designated Roth contribution accounts through in-plan conversions if available. The amount that a plan participant can contribute annually as a designated Roth contribution is limited. 9 It may be possible for a participant to complete an in-plan conversion. Plan document language will specify whether this option is available. In-plan conversions must be completed as a direct rollover within the plan to a qualifi ed Roth account. Participants who complete in-plan conversions must include the taxable portion of their conversions in income for the year under the standard conversion taxation rules. An in-plan conversion of a participant s after-tax account to a qualifi ed Roth account is another tax-effi cient way of acquiring Roth assets because of the pre-1987 grandfather/post-1986 basis recovery rules discussed previously. Reporting distributions of after-tax accounts: Divergent practices have surfaced Recordkeepers have diverged somewhat on how they process and report distributions of after-tax accounts. Therefore, it is important for plan participants to be aware of how their distribution requests will be processed and to work with their tax advisors to understand and properly account for the transactions on their tax returns. The following represents one example of disparate reporting practices in situations where the participant requests a partial rollover of his or her after-tax account to a traditional IRA and a partial distribution or conversion to a Roth IRA. The following example will illustrate two distinct reporting methods some have chosen to use. Example: Sue s 401(k) statement Sue, who works for Slim Solutions, LLC, wants to convert her after-tax account in her 401(k) because she learned the plan allows for in-service distributions, and she has concluded a conversion to a Roth IRA makes sense for her long-range fi nancial goals. Her 401(k) plan account statement reads as follows: Pre-1987 after-tax $20,000 Post-1986 after-tax Employer matching $50,000 Profi t sharing $50,000 Salary deferrals $30,000 (includes $5,000 earnings) $50,000 $200,000 The total amount in her after-tax account, which has been separately tracked, is $50,000. Sue wants to convert and roll over $50,000 to a Roth and traditional IRA, respectively, in the most tax-effi cient way possible. An aggressive approach, one some recordkeepers have espoused, is to process the transaction as follows: > Report a conversion of $45,000 of the after-tax to a Roth IRA, presumably resulting in no tax liability > Report a direct roll over of the $5,000 of tax-deferred earnings to a traditional IRA, resulting in no immediate tax liability. (The $5,000 will be taxed upon withdrawal from the traditional IRA.) In this scenario, Sue would need to fi le Form 8606 to account for the $45,000 conversion to her Roth IRA. A more conservative approach would show the transaction as follows: > Report a conversion of $45,000 to a Roth IRA, resulting in a taxable amount of $4,166.67 and a nontaxable amount of $40,833.33 ($20,000 pre-1987 after-tax recovered tax-free + [$25,000 x ($25,000/$30,000)] = $20,833.33 nontaxable leaving $4,166.67 as taxable) > Report a direct rollover of $5,000 to a traditional IRA resulting in no immediate tax liability. This amount consists of $4,166.67 of after-tax dollars. In this case, Sue would need to report $4,166.67 as taxable income on her applicable IRS Form 1040 to refl ect the taxable portion of the Roth IRA conversion. She also would need to fi le Form 8606 to report the conversion to the Roth IRA and to record an increase in the after-tax amount of $4,166.67 in her traditional IRA. (This will allow Sue to eventually recover an amount equal to $4,166.67 tax-free from the traditional IRA, leaving $833.33 to be included in income upon eventual withdrawal.) A simpler approach would be to just roll the entire $50,000 to a Roth IRA and recognize $5,000 of income tax. As an alternative to the previous direct rollover scenario, a participant could consider an indirect or 60-day rollover. Under this approach a plan participant who is eligible takes a lump sum distribution of his or her after-tax account, subject to standard 20% federal withholding rules, and within 60 days rolls over the pretax amount (the earnings) into a traditional IRA and subsequently rolls over the after-tax amount to a Roth IRA, provided it is still within the 60-day rollover time limit. Of course, by using personal funds, the participant also would have to timely roll over the amount withheld for federal income tax purposes (20% of the pretax amount) in order to avoid including that amount in taxable income. Because converting after-tax accounts is a complicated matter, and plan recordkeeping procedures vary between providers, it is important for plan participants to speak with their tax advisors and direct any questions they may have on the administration of their after-tax accounts to their respective employers and plan administrators. Until the IRS provides guidance on the proper tax treatment of these conversion strategies there is a risk that any of these approaches could be challenged by the IRS. 9 The combined total of pretax salary deferrals and qualifi ed Roth cannot exceed the $17,500 for participants under age 50 and $23,000 for those age 50 or greater for 2014. (3)

Moving ahead with after-tax If a plan participant, working with a tax advisor, is considering a 401(k) employee after-tax contribution strategy, the first hurdle is to determine whether the participant s plan allows for these and tracks them separately.. In order to know whether a participant has an after-tax contribution option in the 401(k) plan, he or she can check with the benefits administrator or personally review the plan document or summary plan description for the plan. If it is discovered that an after-tax option exists and is tracked separately, there are several key questions to consider: > Should the participant contribute to the plan on an after-tax basis and, if so, how much? > Does the plan allow for an in-service distribution of the after-tax account balance? > Should the participant consider a withdrawal, rollover or conversion of the after-tax account balance? > What would be the tax implications in each scenario? The Columbia Management Learning Center The Columbia Management Learning Center is dedicated to supporting fi nancial advisors and their clients with thoughtleading insights, up-to-the-minute regulatory and legislative information, the latest research, new ideas and proven tools in fi nancial planning. Our aim is to be a trusted ally, combining knowledge and know-how to deliver the most innovative fi nancial solutions available. Contact your financial advisor to discuss your retirement planning needs and how the Columbia Management Learning Center can assist you. These are important questions and, ideally, a participant should not go it alone. He or she should rely on a team of tax and financial professionals to offer insight and guidance. Columbia Management Investment Distributors, Inc. 225 Franklin Street Boston, MA 02110-2804 columbiamanagement.com blog.columbiamanagement.com 800.426.3750 This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide legal or tax advice. Consumers should consult with their tax advisor or attorney regarding their specifi c situation. Securities products offered through Columbia Management Investment Distributors, Inc., member FINRA. Advisory services provided by Columbia Management Investment Advisers, LLC. 2013 Columbia Management Investment Advisers, LLC. All rights reserved. FF778302 CM-LC/245189 E (12/13) CLCR1100/778302 (4)