Should You Make After-Tax Contributions to Your Retirement Plan?

Another Way to Save in a Roth Account

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Are you able to contribute up to the maximum amount possible to your retirement plan at work? Most financial planners recommend that you contribute at least enough to get the full matching contribution if you are fortunate enough to work for an employer that offers this.

But why stop there? If you want to achieve true financial freedom, you may need to save more than the amount you may have been initially signed up for during auto-enrollment. This is why it’s always important to know your retirement plan contribution limits.

401(k) contribution limits

The IRS limit for 401(k) contributions is $19,000 in 2019 (plus another $7,000 if you are 50 or older). But most people are unaware that they may be able to save additional money in their employer-sponsored retirement plan.

In some cases, “saving more” means contributing up to the annual total defined contribution limit (from both employee and employer) of $56,000 (plus $7,000 catch up if 50 and older) or 100 percent of your compensation, whichever is less.

This sounds like a great plan if you have the ability to save that much for retirement, but most people aren’t able to max out their retirement plan contributions. But even if you are already fortunate enough to be able to contribute the maximum amount allowed in pre-tax and Roth contributions, there are a few reasons to save more through after-tax contributions to a 401(k) plan or other defined contribution retirement plan.

Ability to withdraw contributions

You should generally be able to withdraw after-tax voluntary contributions, subject to the plan guidelines on withdrawals. That means if you have an emergency, you will be able to access those funds.

However, you may not be able to withdraw associated earnings growth, and if you are, those earnings (but not your original contributions) would be subject to taxes and a 10 percent penalty if withdrawn prior to age 59 1/2.

Make the process automatic

One of the greatest benefits of employer-sponsored retirement plans is the convenience and simplicity associated with automatic contributions. Rather than making a decision to save for retirement, every time you get a paycheck, your saving occurs automatically.

As a result, saving after-tax money in your retirement plan at work is a simple and easy way to ramp up your retirement savings. All you have to decide is the percentage of your salary you want to contribute and how you want that money to be invested. In most cases, your retirement plan investment options are identical to those in your pre-tax and Roth accounts.

Eligibility for a tax-free rollover

The biggest benefits of making after-tax contributions to a retirement plan are usually seen when you decide to leave your company or retire. Your after-tax retirement plan account balance will consist of two important components: your original after-tax contributions and the tax-deferred earnings growth on those original contributions. The IRS allows you to separate these different components during the rollover process.

At the time you leave your company or retire, you have the ability to roll the tax-deferred earnings growth into a traditional IRA and roll your after-tax contributions into a Roth IRA.

The ability to roll after-tax voluntary contributions into a Roth IRA gives you the ability to allow any future earnings growth to occur on a tax-free basis if you leave the money in the Roth IRA for at least five years and until after reaching age 59 ½.

According to the IRS, “earnings associated with after-tax contributions are pre-tax amounts in your account. Thus, after-tax contributions can be rolled over to a Roth IRA without also including earnings. Under Notice 2014-54, you may roll over pre-tax amounts in a distribution to a traditional IRA and, in that case, the amounts will not be included in income until distributed from the IRA.”

For example, assume you are already contributing $18,000 per year to your pre-tax 401(k) plan and you have the ability to save an additional $12,000 through after-tax contributions to the plan. After 10 years, let’s also assume you have about $160,000 from your after-tax contributions ($120,000 in contributions and $40,000 in growth).

In this scenario, you also have $250,000 in pre-tax savings and growth from contributing $18,000 per year (current IRS maximum allowable amount). When you leave your employer to retire or take a new job, you can roll over your after-tax voluntary retirement plan balances into a few different destinations: $120,000 into a Roth IRA and $290,000 into a traditional IRA or your new employer’s defined contribution plan.

Finally, if you move forward another 10 years to retirement, the Roth IRA account alone by itself would be worth approximately double (without any additional contributions), assuming a 7.2 percent annual return and using the Rule of 72. That’s an additional $120,000 of tax-free growth by taking advantage of saving after-tax money in a retirement plan at work.