New payment options for 401(k)s complicate planning

Financial advisers may need to become fortune tellers to help direct client contributions to retirement plans next year.

They’ll have to figure out whether clients will be better off making after-tax or pretax payments. Legislation providing the option is expected to take effect in January.

“Anticipating what the tax situation is going to be like tomorrow is a bit crystal ballish,” says Kathryn Capage, vice president of retirement plan marketing at Aim Management Group in Houston. “It’s a very futuristic kind of situation.”

Ms. Capage adds that the new option “will be a bit laborious for record keepers.”

The legislation will give participants in 401(k) and 403(b) retirement plans the option of contributing after-tax dollars instead of, or along with, pretax dollars.

Pay now or later?

Whether the dollars are taxed before they are invested will not change the maximum annual contribution, which will increase gradually to $15,000, from $10,500.

The main distinction is the option to pay the taxes up front, not when the money is withdrawn. That contrasts with the current method of investing pretax dollars and paying taxes on withdrawals, typically when retirees are in a lower income-tax bracket.

While some retirement specialists scoff at the notion of after-tax contributions, others suggest the issue is not quite that black and white.

“Whether or not to make after-tax contributions depends much more than people like to think on an individual’s financial situation,” says Michael Mares, a partner at the accounting firm Whitt Mare & Co. in Newport News, Va.

“The big advantage is that the money comes out down the road tax free. I can’t say everybody should do it, but everybody should look at it.”

Chuck Yanikoski, president of Still River Inc., a Harvard, Mass., developer of retirement-planning software, already has a beta version of a program to help advisers determine whether after-tax investing makes sense for individual plan participants.

“The traditional thinking is that you should take the tax deduction now while you’re in a higher tax bracket,” Mr. Yanikoski says. “But there is an argument that suggests there will be fewer tax brackets in the future, and you can’t ever predict what Congress will do down the road.”

Mr. Yanikoski’s point is that there is no guarantee that retirement, several years in the future, will mean a low tax rate.

Ironically, Congress’ unpredictability has some industry watchers clinging to the traditional pretax model.

Stuart Miller, executive vice president of the Pittsburgh financial planning firm Bill Few Associates, says the benefits of after-tax contributions are limited.

“Putting after-tax dollars into a retirement account is not something I would recommend,” he says. “I’m cynical that this [after-tax] money may ultimately be taxed when it is taken out.”

As evidence of how laws can evolve, Mr. Miller cites the 1935 Social Security Act, which provided benefits that President Franklin D. Roosevelt said would be received tax-free. They are not tax-free today.

“Congress doesn’t have any respect for what its predecessors have done,” Mr. Miller says.

For Mr. Yanikoski, the uncertainty of the after-tax option is what makes for such an interesting opportunity.

“Everybody will want to have some objective way to answer the question of whether it’s better to invest after-tax money,” he says.

Based on beta tests on his software program, Mr. Yanikoski says there is evidence to suggest that both sides are right. Well, sort of.

After taking into account the primary variables that can influence both pretax and after-tax contributions — such as rate of return, current and anticipated tax rate, and investment time period – the software generally suggests a combination of pretax and after-tax investing.

The program, which involves using the Monte Carlo method of calculating multiple scenarios of randomized values, can be customized for each plan participant. For example, because the after-tax model does not require distributions at age 701/2, an investor anticipating other sources of income in retirement would be steered toward a larger allocation to the after-tax model.

anticipating the law

Saying that Mr. Yanikoski is ahead of the curve with his new software program might be an understatement. The fact that he expects to have the software ready for sale next month says something about his support of the new legislation.

“We basically gambled that the rule would pass in the form it is currently in,” he says.

So far, so good. But Mr. Yanikoski is still counting on plan participants to show an interest in after-tax contributions and on plan administrators and sponsors to offer the option.

“It will depend on the companies that are administering retirement plans,” he says. “The rule enables them to set up the accounts, but it doesn’t require them to do it.”

Tom Clough, president of New York Life Benefit Services in Norwood, Mass., says that regardless of the record-keeping challenges, competitive pressures will force administrators and plan sponsors to start offering the after-tax option.

“Something like this gives plan sponsors a new bell and whistle to work with to encourage investing for retirement,” he says. “The reality is, everybody is going to offer this immediately because they will have to.”

But Ms. Capage says she thinks companies will wait and gauge consumer demand before building an after-tax program to run in conjunction with a pretax model.

“I’m not sure everybody is going to be up and running immediately,” she says.