Retirement Planning

The Pros and Cons of After-Tax 401k Contributions

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After-tax 401(k) contributions are unfamiliar to most people since employers don’t typically offer the option. But, some employers do, and after-tax 401(k)’s may be gaining in popularity.

We were inspired to write about the topic based on the following question from a reader named Josh (submitted in 2016):

“I just started a new job this week and on the 401(k) information sheet I noticed that there was a column with additional after-tax contributions that you can make on top of the $18k contribution limit (In my case this is $20k). After maxing out my Roth IRA, Roth 401(k) and HSA, would it be better to put money into my 401(k) after tax than into a brokerage account? How is this money treated differently than normal Roth 401(k) contributions? It looks like it is now to convert this money into a Roth IRA... "

That’s an excellent question, and the quick - but the inconclusive answer is - it depends! For Josh, it’s unlikely that he’ll be able to convert his after-tax 401(k) contributions to a Roth IRA any time soon, but let’s consider the main points of the after-tax option.

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What Are After-Tax 401(k) Contributions?

After-tax 401(k) contributions are just what the name implies - 401(k) contributions that are made by the employee without the benefit of them being tax-deductible.

Here’s how it works: Under current regulations, an employee may contribute up to $19,000 of pre-tax earnings to an employer-sponsored 401(k) plan ($25,000 if you are age 50 or older). However, the maximum anyone may contribute to any and all tax-deferred retirement plans is $56,000 (or $62,000 if you are age 50 or older).

Considering only employees who are younger than 50, that means that even after making the maximum allowed tax-deferred contribution of $19,000, there is still the potential to contribute an additional $37,000 to your 401(k) plan. The IRS actually permits this, with certain restrictions, but relatively few employers offer it.

One of the major restrictions - and the reason that it isn’t more popular - is that the additional contributions beyond $19,000 are not tax-deductible. Many taxpayers lose interest in contributing to a retirement plan if there is no deduction for doing so.

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Why You Might Make After-Tax 401(k) Contributions

Even though you can’t deduct the contributions beyond $19,000, making them on an after-tax basis can still make a lot of sense. Once the additional contributions are added to your 401(k) plan, they accumulate investment income on a tax-deferred basis, just like the funds in any other type of tax-deferred retirement plan.

In addition, contributing the maximum of $56,000 to your 401(k) plan is nearly three times the usual $19,000 limit. That will enable you to accumulate a lot more money before you retire. And, if you’re planning to retire well before turning 65, after-tax contributions will enable that to happen a lot faster.

There is a catch. The earnings on after-tax contributions, just like all distributions from pre-tax contributions, are taxed as ordinary income. If the money had been invested in a taxable account, most if not all of the gains would be taxed at the lower rate associated with long-term capital gains. But, there is still another advantage that could make after-tax 401(k) contributions irresistible.

The Roth IRA Rollover

This could quite possibly be the golden goose of the whole arrangement. Since your contributions in excess of $19,000 are made on an after-tax basis, you can convert the non-deductible portion of your 401(k) to a Roth IRA...and do so without incurring any income tax liability on the conversion!

Once you roll the funds over to a Roth IRA, you will be converting future withdrawals from tax-deferred to tax-free status.

Without even turning to a calculator, it should be obvious that this represents a tremendous windfall. Imagine if, instead of contributing $6,000 per year to a Roth IRA (the IRA contribution limit), you instead contribute effectively up to $37,000 per year in after-tax 401(k) contributions? Not only will you accumulate a fortune, but again, that produces income for you on a tax-free basis in retirement.

Recommended Reading: Maxing Out Retirement Accounts: How Rich Could You Be?

This is even better than doing the standard Roth IRA conversion since that tactic typically requires paying tax on the amount converted. Since you never received a tax deduction on your after-tax 401(k) contributions, there will be no tax on the conversion.

The IRS allows you to rollover the amount of the after-tax 401(k) contributions to a Roth IRA, while the amount of your accumulated investment earnings and pretax 401(k) contributions are rolled over into a traditional IRA (Source: Morningstar).

What About Regular Roth 401(k) Contributions?

The limitation with regular Roth 401(k) contributions is that in combination with contributions to your regular 401(k) plan, you cannot contribute any more than $19,000 per year in total. Using the after-tax 401(k) contributions, your contributions to a Roth plan can be dramatically higher.

What About Just Contributing to Regular Taxable Accounts Instead?

This is certainly a reasonable idea. In fact, before you even consider taking full advantage of after-tax 401(k) contributions, you should first make sure that you have a sufficient amount of money held outside of retirement savings to provide you with short-term liquidity, as well as for medium-term goals. Those goals include any spending plans that will need to be funded before you retire.

Only when you have a sufficient amount of savings and investments to handle those spending priorities should you consider putting additional money into after-tax 401(k) contributions.

Your after-tax 401(k) contributions should be something you do only when all other spending and retirement priorities have been met. Despite the obvious advantages of tax-deferred and tax-free investment earnings, you should always have an adequate amount of money held outside of your retirement plans that you can access quickly and easily if you need to.

How After-Tax 401(k) Contributions Work

Though employee contributions are limited to $19,000 (or $25,000) per year, you can actually contribute up to the overall plan maximum- which is the lesser of $56,000 or of 100% of your actual earnings.

It’s important to understand that rolling your after-tax 401(k) contributions into a Roth IRA is not at all an automatic process. While you are working for your employer, you contribute to your 401(k) using both pretax and after-tax contributions, and both will earn investment income on a tax-deferred basis.

In order to be able to roll over your after-tax contributions to a Roth IRA, you generally must separate from your employer -either through retirement or through resignation/termination. (Some companies allow in-service rollovers, but it's not common. See below for more details.) Once you do the funds will be released to you, as is normally the case with employer-sponsored retirement plans.

You will then have to calculate the after-tax contributions that you made to the plan.

Typically, pretax contributions and your overall 401(k) plan investment earnings are rolled over into a traditional IRA, so there will be no immediate tax liability and funds will continue to be tax-deferred. Your after-tax 401(k) contributions can be rolled over into a Roth IRA again with no tax consequences, since there was no tax deduction taken - and begin earning investment income on a tax-free basis.

As a rule, the most logical contribution sequence should be:

  1. Make the maximum pre-tax contribution you can (or at least sufficient to get the maximum employer matching contribution).
  2. This should include making the maximum Roth 401(k) contribution (so you can take advantage of tax-free earnings from the very beginning).
  3. Make the maximum after-tax 401(k) contribution.

Your after-tax 401(k) contributions will be included within your regular 401(k) plan and will earn investment income on a tax-deferred basis. The real benefit, of course, will take place once you leave your employer. You can rollover the after-tax contributions into a Roth IRA, where the investment earnings will be tax-free.

This will also have benefits in the event that you take some or all of your 401(k) money directly after leaving employment, rather than rolling it over to an IRA. Since part of your 401(k) distribution will be comprised of non-deductible after-tax contributions, that portion will not be subject to income tax upon withdrawal.

There is a special provision of the tax code - IRC Section 402(c)(2) - that allows you to get your after-tax contributions back immediately if you are retired.

For example, if you have $500,000 distributed from your 401(k) plan when you retire, and $100,000 of it represents after-tax 401(k) contributions, you have the option to receive that after-tax contribution amount in a lump sum with no tax consequences. The remaining balance of the plan can be rolled over into an IRA.

In-service transfers. This is something of a long shot, but if your employer allows you to make in-service transfers from your 401(k) plan to an IRA, you may be able to begin converting your after-tax 401(k) contribution money to a Roth IRA without terminating your participation in the 401(k) plan. Most companies do not offer this option, nor are they required to by law, but it’s certainly worth investigating. If it is permitted, you can begin taking advantage of tax-free investment earnings in your Roth IRA rollover account immediately, rather than waiting until you leave the company.

How to Know If Your Employer Allows After Tax 401(k) Contributions?

Despite the fact that after-tax 401(k) contributions are permitted within the tax code, employers are not required to offer the benefit. In fact, a report in Kiplinger's noted that probably no more than 10% of employer-sponsored 401(k) plans actually allow it.

If you're not sure if your employer is one of the participants, contact whoever in the organization is the contact point on the 401(k) plan and start asking questions. It may very well be that your employer does allow it, but doesn't necessarily make that common knowledge.

If they don’t offer it, you may want to see if you can initiate some interest. Be prepared to not only explain how the program works but also how it will give the employer a competitive edge in retaining staff and in recruiting new talent. Since only a minority of employers allow it, this could be a major retention and recruiting tool that will benefit the employer.

Further Reading: How much should you be saving for retirement


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