Typical 401(k) plans allow you to contribute in two ways: make elective deferrals through pre-tax dollars and contribute post-tax dollars via designated Roth contributions. However, 25% to 35% of 401(k) plans allow for a third type of contribution: after-tax contributions.
These contributions offer some key advantages over pre-tax and designated Roth contributions that make them a good option in certain financial situations.
Basics of After-Tax 401(k) Contributions
Like designated Roth contributions to a 401(k), non-Roth after-tax contributions are contributions made from compensation with dollars that have already been taxed. These contributions don't reduce your income, so you can't deduct them on your tax return.
Contrast this with pre-tax contributions, which you exclude from your income, so you can deduct the contribution amount on your taxes.
Benefits of After-Tax Contributions
Putting money into your 401(k) account using this third option can also help maximize your contributions, lower your tax burden, and streamline your contributions.
The legal limit for pre-tax elective deferrals and designated Roth contributions is $19,500 in 2020 and 2021 (plus another $6,500 in catch-up contributions if you are 50 or older).
Granted, many people aren't able to max out their pre-tax and designated Roth contributions, and if this describes your situation, this limit may not seem restrictive. However, if you have the financial means and the desire to save more than the limit, you can't do so with pre-tax or designated Roth contributions. You can do so with after-tax contributions if your 401(k) allows them.
Higher 401(k) Contribution Limits
This is because the total contribution limit for defined-contribution plans in 2020 is $57,000 (plus $6,500 in catch-up) or 100% of your compensation, whichever is less. The total contribution limit for 2021 is $58,000 plus $6,500 in catch-up. This amount includes pre-tax and designated Roth contributions, employer contributions, and after-tax 401(k) contributions, so the limit that you can invest through after-tax contributions amounts to $57,000 or $58,000 minus your total pre-tax, designated Roth, and employer contributions.
For example, if you max out your pre-tax and Roth contributions and receive a total of $6,000 in employer contributions in 2020, you could contribute up to $31,000 in after-tax contributions to a 401(k) plan that allows these contributions.
The $57,000 figure is the total amount you can contribute in 2020 to retirement plans offered by the same employer. The total for 2021 is $58,000.
Limited Tax Liability Upon Withdrawal
Your retirement plan account balance includes two important components: your original contributions and the earnings on those original contributions. Depending on the type of contribution you make, either, both, or neither of these amounts may be taxed.
When it comes to the tax treatment of the three 401(k) contribution options upon withdrawal, designated Roth contributions have the edge; qualified contributions and earnings are both tax-free upon withdrawal.
Pre-tax 401(k) plans impose the largest tax liability at the time of withdrawal; both the contribution and the earnings are taxable because you deferred paying taxes at the time of contribution.
After-tax 401(k) contributions offer reduced tax liability compared to pre-tax contributions since you can withdraw after-tax contributions tax-free, subject to the plan guidelines on withdrawals. However, the earnings are considered pre-taxed amounts, so they are generally taxable upon distribution. Moreover, those earnings would be subject to taxes and a 10% penalty if withdrawn prior to age 59 1/2.
Eligibility for Rollovers
After-tax contributions also mitigate your tax burden in retirement in another way. At the time you leave your company or retire, you will have the ability to roll the tax-deferred earnings growth into a traditional Individual Retirement Arrangement (IRA) and roll your after-tax 401(k) contributions into a Roth IRA.
This means that your earnings can continue to grow on a tax-free basis if you leave the money in the traditional IRA until after reaching age 59 1/2. That’s because the IRS considers the earnings associated with the after-tax contributions as pre-tax amounts.
For example, assume you are already contributing $19,500 per year, pre-tax, to your 401(k) plan and you have the ability to save an additional $12,000 through after-tax contributions to the plan. After 10 years, assume you have $160,000 from your after-tax contributions ($120,000 in contributions and $40,000 in earnings).
In this scenario, let’s say that you already have $250,000 in pre-tax savings and earnings. When you leave your employer to retire or take a new job, you can roll your non-Roth after-tax retirement plan balances into two different accounts. That $120,000 in after-tax contributions would go into a Roth IRA. And $290,000—the $40,000 in earnings from those contributions plus the $250,000 from your pre-tax contributions to your 401(k)—would go into a traditional IRA or your new employer’s defined-contribution plan.
10 Years Later
Move forward another 10 years to your retirement. If your Roth IRA account had a 7.2% annual return over the ensuing years, that account alone could be worth approximately double (without any additional contributions). That would leave you with an additional $120,000 of tax-free growth by saving after-tax money in a retirement plan at work.
The calculation above uses the "Rule of 72," a common approach for calculating how long it will take for your investment to double in value. Just divide 72 by the expected rate of return to figure out how long it will take for your investment to double.
Automatic After-Tax 401(k) Contributions
One of the greatest benefits of employer-sponsored retirement plans is the convenience and simplicity associated with automatic contributions. Every time you get a paycheck, you save for retirement automatically without having to think about it.
That makes saving after-tax money in your work retirement plan just as simple and easy. All you have to decide is how much of your salary you want to contribute and how you want that money to be invested. In most cases, your retirement plan investment options for after-tax contributions are identical to those in pre-tax and designated Roth accounts.
When After-Tax 401(k) Contributions Make Sense
If your 401(k) plan offers them, consider this contribution option if:
- You're a high earner. While many people aren’t able to max out their pre-tax retirement plan contributions, If you are fortunate enough to earn a salary that causes you to regularly hit the annual contribution limit, you can save more through after-tax contributions to a 401(k) plan or another defined-contribution plan.
- You want to maintain emergency savings. Since you can withdraw your after-tax contributions tax-free, you can dip into them if needed to cover unplanned expenses in the future.
- Your income fluctuates. If you work a seasonal job, for example, your income may change each year. In years when you earn a lot of income, you can boost your savings potential through after-tax contributions. When times are lean, you can make pre-tax or designated Roth contributions within the contribution limit.