Are You Taking Advantage of this Little Known Microsoft Retirement Plan Benefit?

KEY TAKEAWAYS

  • Microsoft has a 401(k) option that allows employees to contribute an additional $20,000 in after-tax contributions each year.
  • Surprisingly, many Microsoft employees do not take advantage of this benefit, or even know about it.
  • When executed correctly, employees may convert the after-tax contributions in their 401(k) into their Roth 401(k) and only owe tax on the earnings portion.

 

Most employees at Microsoft know they should participate fully in the Microsoft 401(k) program, but few take full advantage of all of the generous retirement benefits Microsoft has to offer. Sure, they may be contributing the maximum $18,000 a year ($24,000 a year if over 50) to their 401(k) and receiving the maximum $9,000 company match. Not bad at all, but they are only capturing a fraction of the benefits available to them via the Microsoft 401(k) plan.

One of the most generous, but under-utilized retirement benefits is called the “After-Tax Contributions.” Microsoft has added a provision to its company 401(k) plan that allows employees to make substantial additional after-tax contributions to their 401(k)s.

Most Microsoft employees believed they have maxed out their retirement contribution once they reach $18,000 ($24,000 if 50+). In reality, they are leaving an additional $20,000 in after tax contributions on the table. Employees may roll over the after-tax contributions of their 401(k) into a Roth IRA and the earnings portion to an IRA. That’s right, as long as the contributor is still employed at Microsoft, he or she can effectively make an additional Roth IRA contribution of $20,000 each year with no additional taxes due and put more dollars into their IRA.

Alternatively, an employee can keep the funds invested in the Microsoft 401(k) plan and have the after-tax portion automatically convert to a Roth 401(k) each quarter. A pro-rata portion of the after-tax earnings converted are reported as taxable income. At the end of the year, Fidelity sends plan contributors a 1099-R if they go this route so they can pay tax on the earnings portion. Since the conversions are done on a quarterly basis, contributors can expect the earnings portions to be relatively small.

Benefits of a Roth 401(k) and a Roth IRA

If a saver is over age 59 ½ and has had his or her assets in a Roth IRA for a minimum of five years, then the funds may be withdrawn tax-free. The saver is not required to pay income tax OR capital gains tax on qualified distributions. Having these tax-free assets in a well-structured financial plan can also help savers manage taxes during retirement. Further, assets in these accounts are not subject to required minimum distributions (RMDs) during the saver’s lifetime and can be passed on to the saver’s beneficiaries tax-free as well.

Real World Example

When should an employee take advantage of these advanced retirement savings techniques? It depends on one’s personal financial situation, but this example should help clarify the picture:

Sarah is a 45 year-old Director at Microsoft who earns $300,000 per year in total compensation. Sarah plans to save around $50,000 per year and wants to maximize her options. She is contributing $18,000 to her pre-tax 401(k) every year, and also receives the company’s generous $9,000 (50%) in matching dollars. With her remaining savings dollars, she invests in low cost mutual funds through a taxable brokerage account.

Sarah is making several smart moves, but she is missing out on a significant opportunity. The funds in her taxable brokerage account will create capital gains and dividends which she will likely owe taxes on each year. When she sells these mutual funds, she will also owe taxes on the growth of the funds. Sarah could have instead elected to contribute an additional $20,000 per year to the company’s after-tax 401(k) and had those contributions converted automatically to a Roth 401(k) each quarter. The contributions would convert with no tax consequences and the earnings would be taxed as regular income. Once the funds are in the Roth 401(k), the earnings on that account will grow tax-free and investors like Sarah could roll the Roth 401(k) portion of the account into a Roth IRA when they retire or when they leave Microsoft.

Sarah will still be contributing a portion of her savings to her taxable brokerage account, but being able to move $20,000 into a tax free account, that would have otherwise remained in a taxable account, is truly maximizing her options.

Important Notes:

  1. After-tax contributions are not eligible to receive the company match, so savers should be sure to make the full $18,000 in pre-tax or Roth contributions.
  2. No federal or state taxes are withheld from the Roth In-Plan Conversion amount. Fidelity sends savers a Form 1099-R at year-end and it is the saver’s responsibility to account for all taxes due when filing their taxes for that given year.
  3. The 5-Year rule still applies to Roth Conversions to Roth IRAs and to Roth 401(k)s.
  4. Each person’s financial situation and tax situation is unique. Be sure to consult a tax advisor before implementing any changes to one’s plan.

Contact an advisor at Soundmark Wealth Management to discuss this and other Microsoft financial benefits and to help you implement the best strategy for your situation.

 

James Nevers, CFP® is an Associate Advisor at Soundmark Wealth Management, LLC. James works closely with physicians, business owners, Directors and Executives at Amazon, Microsoft, and Boeing, and other high-net-worth individuals to help them define their financial goals and implement an ongoing financial planning process.