July 13, 2020
Switching Jobs, Switching Your Retirement Savings Strategy
Please read important disclosures and index definitions HERE
July 13, 2020
Please read important disclosures and index definitions HERE
The economic impact of COVID-19 has created high unemployment and volatility in the employment market with many leaving previous jobs and starting anew at a different employer. A new job presents the chance to accelerate your retirement savings strategy and the following describes three ways to consider.
Roll Over Your 401(k)
As of January 2018, the median number of years that employees remain at an employer is 4.2 years, according to the Bureau of Labor Statistics.1 Gone are the days when you stay with the same company for your entire career. Thus, it is likely you will have multiple 401(k) accounts. If you haven’t already done so, we recommend that you consolidate your previous 401(k) accounts into your current employer’s 401(k) if the plan allows.
Many new clients come to B|O|S with multiple 401(k) accounts. Since the accounts are scattered about, it’s difficult to track each account’s investment details or have visibility into performance. Do you know how these old plans are invested? Do you understand your total asset allocation? How well has your 401(k) performed relative to key benchmark indices? How much do you have in retirement assets? These questions are much easier to answer when you are only evaluating one 401(k) account.
401(k) Rollups: Paving the Way for Annual Roth IRA Contributions
If you are a high earner, rolling up any pretax funded IRA assets into a new 401(k) (if the plan allows) helps pave the way for you to make annual “backdoor” Roth IRA contributions. This is a lesser-known, technical approach that is available when you switch jobs.
Let’s first establish the core concepts of saving beyond a 401(k) and the benefits of the Roth IRA. A fundamental rationale for saving for retirement is to provide you the freedom from having to work your entire life. Having more money in retirement assets may give you the option to retire early or have more financial freedom in your later years. A 401(k) plan is a powerful retirement savings tool, but it has limits, specifically a maximum 2020 pretax employee contribution amount of $19,500 plus an additional $6,500 for those age 50 and older. However, your compensation level may allow you to save beyond these maximums through a Roth IRA, another type of retirement account that can be funded up to a $6,000 per year maximum in 2020 plus $1,000 for those age 50 or older.
Roth IRA assets are attractive for two key reasons. First, Roth IRA accounts provide the benefit of tax-free (not tax-deferred) growth because they are initially funded with after-tax dollars. Second, having Roth assets will provide you with less tax liability when managing your taxes later in retirement. This is in contrast to pretax funded retirement accounts such as a traditional 401(k) or IRA for which each withdrawn dollar is taxed at ordinary income rates.
If you are convinced it’s worth contributing to a Roth IRA, there are two contribution prerequisites: 1) your income must be below specific limits (in 2020, $124,000 for single filers or $196,000 for married people filing jointly) for a direct Roth IRA contribution or 2) if you earn more than the limits, you must first make a nondeductible traditional IRA contribution and then immediately distribute the contribution to your Roth IRA. This is the backdoor Roth IRA contribution mentioned earlier and it’s a two-step process. First, make a deposit of up to $6,000 into an IRA. This contribution will not be deductible against taxable income and you should inform your CPA of the deposit. Second, request that the account custodian transfer the funds from the IRA account to the Roth IRA.
Backdoor Roth IRA contributions are more tax-efficient if you do not have any pretax IRA assets as you will avoid the IRA Aggregation Rule and pro-rata basis calculation. When an IRA has received nondeductible contributions, the distribution of those dollars is received tax-free as a return of after-tax contributions. However, the IRA Aggregation Rule throws a curveball in this process. This rule stipulates that when determining the tax consequences of an IRA distribution, such as the distribution from a nondeductible IRA to a Roth IRA for a backdoor Roth IRA contribution, the year-end value of all IRA accounts will be aggregated together for tax calculations. Then, a calculation must be made to determine how much of the distribution will be a return of principal on a pro-rata basis. The bottom line is that if you have several IRA accounts funded with both pretax and after-tax contributions, then a portion of your annual backdoor IRA contribution will be taxable, which reduces some of the benefit of the technique.
For example, Julia has two IRA accounts that total $50,000. The first IRA was funded with $44,000 of pretax dollars. The second IRA was just funded with an annual $6,000 nondeductible IRA contribution. If Julia wants to transfer her $6,000 IRA contribution to her Roth IRA, she can’t just take out the $6,000 of after-tax contributions on a tax-free basis due to the pro-rata rule. To calculate the tax consequences, Julia must divide the nondeductible IRA contribution ($6,000) by the total amount in the IRA accounts ($50,000) to arrive at a 12% after-tax rate. Thus her $6,000 withdrawal will have $720 of after-tax funds (12% of $6,000) while the other $5,280 will be considered taxable income.
If you do not have IRA assets funded with pretax assets, you can avoid the pro-rata calculation as explained above. Thus, after changing jobs, inquire whether your new employer’s 401(k) plan will accept rollovers of your previous 401(k) accounts and rollups of pretax IRA assets. If so, you can place all your pretax funded retirement assets into a single 401(k). You will then have an empty IRA account open simply as a transfer point for making annual backdoor Roth IRA contributions.
Does Your New 401(k) Plan Accept After-Tax Contributions?
Some employers’ 401(k) plans allow for after-tax contributions, which may be appropriate for high earners who are able to save beyond the 2020 $19,500 employee deferral limit. The benefit of making after-tax contributions in a 401(k) is that the earnings are tax-deferred until withdrawal later in retirement. The after-tax contributions are not taxable. The total 401(k) contribution limit for 2020 is $57,000 including the employee deferral, employer contributions, and after-tax employee contributions. For example, if an employee who is not yet 50 years old maxes out their 401(k) in 2020 and their employer contributes $7,000, their after-tax contribution limit will be $30,500 ($57,000 – $19,500 – $7,000 = $30,500).
Putting It All Together
A new job gives you an opportunity to rethink your approach to retirement savings. Find out if your new plan allows 401(k) rollovers, IRA rollups, and 401(k) after-tax contributions. If your plan allows, in 2020, you will be able to invest the following amounts toward retirement:
This significant savings strategy may help put you in the position to build more wealth over the long run or for an early retirement.
1. Bureau of Labor Statistics, “Economic News Release: Employee Tenure Summary,” September 20, 2018, https://www.bls.gov/news.release/tenure.nr0.htm