Participate in Your Lockheed Martin 401(k) Plan? Don't Miss These Tax Planning Opportunities

If you have After-tax dollars inside your Lockheed Martin 401(k), you should pay close attention!
On September 13th of this year, the House Ways and Means Committee released their American Family Plan tax proposals. The legislation touches on a wide range of tax issues, from increasing the top ordinary income tax bracket to cracking down on popular retirement account strategies, such as the Mega Back Door Roth Conversion we speak about below.
Although still only a proposal, not a law, learn about this tax strategy that may only be around until year end.
For employees who participate in this 401(k), there are several impactful options available to them beyond investment choices. These opportunities are often missed because employees are unaware that they exist, or they do not understand the positive impact they may have.
The opportunities we discuss in this article, saving additional money in your plan via after-tax contributions, is worth considering because it can both significantly boost your retirement savings as well as allow you to move more money into a Roth 401K or Roth IRA.
What is it? The Lockheed Martin 401(k) plan allows employees to save in a few different ways: Pre-tax, Roth Contributions or after-tax. To understand exactly what options you have access to, a call to your plan administrator is a good place to start.
Let’s define what after-tax contributions are. After-tax contributions are elective deferrals made from already-taxed salary (like Roth contributions, but different as we explain below). Each contribution type has some different nuances, pre-tax contributions mean your contributions are taken from your paycheck before taxes are deducted. That means you lower the amount of income you have to pay taxes on, which can soften the blow to your take-home pay today, but all distributions in the future will be taxed as ordinary income. Roth contributions are made from your pay that has already been taxed, so you will not receive a tax deduction for the contribution today, but all future distributions (contribution amounts and earnings) will be tax-free if certain rules are met. After-tax 401(k) contributions are the kind that don’t earn you a tax deduction either. However, the big differences between Roth 401(k) contributions and After-tax 401(k) contributions are their dollar limits and how their earnings are taxed. Continue reading to see why this makes after-tax contributions very much worth considering!
What are the dollar limits? There are limits on the amount of elective deferrals (pre-tax and Roth contributions) that a participant can make in a calendar year (for 2021, $19,500; or $26,000 if age 50 or older). However, after-tax contributions do not count against this limit. However, After-Tax contributions, along with all elective deferrals and employer contributions (such as matches), do count against a much higher overall annual limit – for 2021, $58,000 (or $64,500 for over-age-50 employees who defer the additional $6,500). So, an employee who has maxed out on elective deferrals likely will still have enough room to make substantial after-tax contributions. Unfortunately, not all employer plans allow for after-tax contributions; the good news is that Lockheed Martin 401(k) Plan is one that does.
For Example: Janet, age 52, participates in her 401(k) plan that allows after-tax contributions. For 2021, she elects to make pre-tax elective deferrals up to the $26,000 limit. Her employer’s matching contribution is $5,000. If she can afford it, Janet could make up to $33,500 [$64,500 – ($26,000 + $5,000)] in after-tax contributions as well.
I’m confused. Aren’t After-Tax Contributions the Same as Roth Contributions?
No, absolutely not. Although Roth contributions are made on an after-tax basis, when people talk about “after-tax” money in an employer plan, they are usually talking about funds contributed to the “traditional” side of the plan, but for which no tax break was received. The biggest difference between the two is the tax treatment when distributions are taken in future. While both Roth 401(k) salary deferrals and their earnings can be distributed tax-free (if part of a qualifying distribution), the gains earned on any after-tax contributions to the plan are generally taxable when distributed.
Why Would I Want to Put After-Tax Money into my 401(k)?
Because of these two opportunities:
1). In-Plan Conversions:
Your plan has a Roth component and usually allows for in-plan conversions which will let you convert all or some of your savings to the Roth side inside of your Plan. Any pre-tax money on the traditional IRA side, both contributions and earnings, will be taxable today if you convert it. If you convert your Traditional after-tax savings, you pay taxes today on only the market gains (earnings) of the after-tax dollars you convert. In the future, you can withdraw any money you convert to the Roth 401(k) tax-free, provided your distribution is considered “qualified”. (Generally, a distribution of Roth savings in considered qualified if you are at least age 59 ½ and your initial Roth contribution was made at least five years prior to the distribution.) But note: converting your after-tax savings to Roth 401K is a permanent change and cannot be undone later.
2). The Mega Backdoor Roth.
As well as converting inside of your plan, the ability to make large after-tax contributions may provide the opportunity to do a “Mega Backdoor Roth”, converting those contributions out of the plan and into a Roth IRA. This option will provide you with greater flexibility as to how you invest and manage your funds going forward as they will not be ruled by the plan any longer. But the devil here is in the details.
What is a mega backdoor Roth conversion? Quite simply, it’s the employer-sponsored retirement plan equivalent of the Back-Door Roth IRA. Since plan contribution limits are higher than IRA contribution limits (2021, $7,000 per year with after-50 catchup), there’s the potential, in limited circumstances, to facilitate a transaction similar to the Back-Door Roth IRA, but with much greater dollar amounts.
There are certain conditions that must be met in your Plan to be able to utilize this strategy. You must be able to make periodic in-service distributions of your after-tax money (and their earnings). To find out what you are eligible to do, we recommend starting with a call to your plan administrator.
What Else Should I Be Aware Of?
Beware the pro-rata rules. When a plan contains both pre-tax and after-tax amounts, distributions from such plans must be made on a pro-rata basis. If you are allowed to do in-service distributions, the pre-tax and after-tax portions of that distribution can be split, allowing the pre-tax money to be rolled to a traditional IRA while the after-tax portion (but not the earnings) is converted, tax free, to a Roth IRA. However, the pro-rata calculation for the distribution generally only includes funds a client is eligible to take a distribution of at the time. If there are certain funds to which a participant is not currently entitled, then those funds are not factored into the calculation.
With the pro-rata rules in mind, a young (pre-59 ½, as they usually do not have access to their pre-tax and Roth contributions) client can make after-tax contributions to their plan on an ongoing basis. Then, periodically (and preferably before there are significant gains on those amounts), they can take a distribution of those funds and convert them to a Roth IRA. Since any pre-tax and/or Roth salary deferrals they have, along with their earnings, would generally be inaccessible, the pro-rata calculation would typically only consider the client’s after-tax funds and their respective earnings. Therefore, the converted funds will be all or mostly after-tax money, and the conversion will be virtually tax-free.
Important Caveat
There are a few potential traps to be aware of and rules to follow in order to make these transactions work as intended, so be sure to speak with a qualified tax and/or financial advisor first!
Tax-free income in retirement is a great advantage, but a Roth conversion is not for everyone. To decide whether a Roth conversion is right for you, you need to consider your current and future tax rates, among other factors. If you would like to learn how this strategy may fit in with your retirement planning, schedule a call with us today!