The Tax Consequences of Non-Elective Contributions
As an airline pilot, you can receive up to 16% non-elective contributions in your 401k, depending on the airline. It sounds great — and it is — but it does have some serious tax consequences few pilots think about. When your company contributes 16% of your income in pre-tax dollars to your 401k, they get a tax deduction on the amount they contribute — but someone still has to pay taxes on those dollars, and that someone is you.
While these dollars grow tax-deferred, you’ll pay ordinary income taxes when you pull them out later. The current mandatory retirement age for pilots is 65, so you’ll probably take distributions then, but the bigger issue is when required minimum distributions (RMDs) begin. This is when you’re forced to start taking distributions from your pre-tax accounts because Uncle Sam wants his cut.
Thanks to the SECURE 2.0 Act, passed in December 2022, we have more time to plan for RMDs. While RMDs used to begin at age 72, that age has been pushed back to 73 as of 2023. Starting in 2033, the age at which RMDs begin will be pushed back to 75.
Not to get too in the weeds, but when it comes to RMDs, the amount you’ll need to withdraw in any given year depends on the value of your pre-tax account as of December 31 of the prior year. And due to the pay structure for pilots, most will max out their 401ks for most of their careers. Add in compounding interest (which some call the eighth wonder of the world), and you get a big balance of pre-tax dollars that you and/or your beneficiaries will have to pay taxes on. And let’s not forget that we’re currently in a low-tax environment, so taxes will probably only go up from here.
Fortunately, there are several things you can do to prepare. The goal is to minimize the amount of dollars you have in pre-tax accounts now so that we can minimize your RMDs in the future, thereby minimizing your — and your beneficiaries’ — tax liability.
Consider the following three strategies:
- Contributing to your Roth 401k and Roth IRA: In general, there are two buckets you can contribute to in your 401k: the pre-tax bucket (which is where company contributions go) and the Roth bucket (the investment vehicle where you pay taxes now on the money you put in). In a Roth, your investment earnings grow tax-free, and all your distributions are also tax-free (subject to certain requirements). The rule of thumb is to contribute to Roth accounts now if you think your future income will be more than your current income. This practice helps minimize the balance of your pre-tax dollars, thus decreasing your RMDs. The ability and logicality to contribute to Roth accounts depends on your financial situation and goals.
- Doing Backdoor Roth Contributions/Roth Conversions: Roth accounts are so good that your ability to contribute to them is limited by the amount of money you make. Being an airline pilot, you’ll meet this threshold pretty quickly, so your time to contribute to a Roth IRA is limited. However, there are loopholes. A backdoor Roth contribution is where you redirect your IRA contributions to your Roth IRA — the logistics are more complicated, but that’s the general idea. Roth conversions, on the other hand, take a portion of the dollars you have sitting in an IRA and convert them to the Roth IRA. Some airline retirement plans even allow you to convert employer contributions to your Roth 401k; however, be prepared to pay taxes on converted funds. Your wealth advisor and CPA should assist you with this strategy. And again, the logicality to engage in these practices depends on your financial situation and goals.
- Engaging in Tax-Loss Harvesting: This is my personal favorite — and it’s a little harder to explain. Tax-loss harvesting turns down markets into opportunities. It’s a real-world example of turning lemons into lemonade. Tax-loss harvesting is the process of selling funds in your taxable account at a loss, buying similar funds to keep your allocation the same, then banking those losses for future use. The earlier you start, the more losses you can bank. How do we use these losses to your advantage? Currently, you can offset up to $3,000 of your ordinary income with these losses. However, that’s not what we want to use them for if the goal is to decrease your RMDs; we want these losses to offset capital gains from your taxable account. If done correctly, you would’ve grown your taxable account enough to rely on it for income when you retire — at least for a few years. A portion of those distributions is a return of capital (meaning no taxes are due on this amount), and the other portion is capital gains, which we could offset with the losses you harvested. This strategy can allow you to have very little (sometimes even $0) in tax liability; that’s when you convert those pre-tax dollars to Roth. Tax-loss harvesting not only requires a lot of attention to the market’s daily movements but also having enough time to take advantage of the situation when the market is down. Comprehensive wealth managers don’t have the time to do this effectively, and you as a pilot certainly won’t have time to do this either. You would need your own investment manager, whose job is to care for your portfolio, as well as a wealth manager who understands your complete financial situation.
I want to reiterate that the decision to deploy any or all of the above strategies should be contingent on your unique situation. CERTIFIED FINANCIAL PLANNER™ professionals are taught to know a little bit about everything, and these strategies go deep into investments and taxes — so it’s wise to work with a wealth manager who also has an investment manager and a CPA on their team.
At Creative Planning, we strive to increase our clients’ financial IQ. An informed choice is a wiser choice, and an informed client makes a stronger partner. What destinations can we reach together? To learn more, please schedule a call.