After-Tax 401(k) Contributions

Are you looking to make the most out of your retirement savings? One way to supplement your Social Security income down the line is through after-tax 401(k) contributions to your employer’s retirement plan.

While many people are familiar with pre-tax contributions to traditional 401(k)s and traditional IRAs, an after-tax contribution to a traditional 401(k) is a lesser-known savings method that can significantly lessen your lifetime tax obligation as well as optimize your broader financial plan.

This blog post will dive deep into after-tax 401(k) contributions and discuss how they differ from pre-tax contributions, helping you to maximize retirement savings and lock in at least partially tax-free withdrawals in your golden years.

We’ll explore the ins and outs of after-tax money, the advantages and disadvantages, and strategies to help you make the most of your contributions.

How Do After-Tax 401(k) Contributions Work?

After-tax 401(k) contributions are made using income that has already been taxed. This is unlike pre-tax contributions to traditional 401(k)s, which are made with pre-tax dollars. This difference has important implications for your overall retirement savings strategy, and, consequently, your lifetime tax liability.

Note that after-tax 401(k) contributions are similar to Roth 401(k) contributions, they don’t work in exactly the same way.

Here are some key points to remember:

• While pre-tax contributions to your retirement account reduce your taxable income in the year they’re made, after-tax contributions don’t reduce your income taxes in the same way. Instead, you pay tax before making after-tax contributions to your 401(k) plan.
• Tax-deferred contributions are taxed when you take distributions in retirement, while after-tax contributions are not (perhaps the most attractive part of making after-tax contributions!)
• After-tax contributions can offer tax-free growth, but any growth or earnings on those contributions will be taxed at ordinary income rates upon withdrawal.

The IRS sets annual contribution limits for 401(k) accounts, including catch-up contributions for those aged 50 and older. Understanding these limits and their rules is crucial for maximizing your retirement savings through after-tax contributions.

• In 2023, the individual contribution limit — as it relates to elective payroll deferrals — for a traditional 401(k) is $22,500 (with $7,500 in catch-up contributions if you’re 50 or over).
• The total limit is $66,000, including employer contributions. For those eligible for the catch-up contribution, the annual limit is $73,500, including employer contributions.
• Note that because you aren’t receiving a tax deduction for your after-tax 401(k) contributions, these amounts count towards the $43,500 limit that includes employer contributions.

To make the most of your 401(k) contributions, you may want to consider working with a qualified and properly credentialed financial advisor to navigate the complexities of retirement planning and to ensure you’re on the right track.

Advantages of After-Tax 401(k) Contributions

In this section, we will explore the various benefits of making after-tax 401(k) contributions as they relate to your personal finances. Understanding these advantages can help you maximize your retirement savings and create a more secure financial future.

Tax-Deferred Growth

One of the main benefits of making after-tax 401(k) contributions is tax-deferred growth. When you withdraw your after-tax contributions in retirement, you won’t pay income taxes on any contributions withdrawn, but you will be taxed on any growth and earnings that originated from those after-tax contributions.

These tax-advantaged withdrawals can be especially valuable when you retire, since you’ll also likely be taking Social Security, and you might also have expensive Required Minimum Distributions (RMDs) to consider from other wholly tax-deferred accounts.

Higher Overall Contributions

After-tax 401(k) contributions allow you to contribute more to your retirement account beyond standard pre-tax deferral limits. Maximizing your after-tax contributions can potentially help you reach your retirement savings goals even faster.

Remember that the total amount you can contribute will consider catch-up contribution amounts, contributions from your employer match program, and your normal employee contributions (also called elective deferrals).

Potential Benefits for High-Income Earners

After-tax 401(k) contributions can benefit high-income earners in a higher tax bracket who may be ineligible for Roth IRA contributions (due to income limits) and have already maxed out a traditional IRA.

By making after-tax contributions to their respective 401(k) plans at work, high-income earners can make use of another tax-advantaged savings option to support their retirement planning goals.

Disadvantages of After-Tax 401(k) Contributions

While after-tax 401(k) contributions offer several benefits, they also have drawbacks.

Understanding these potential disadvantages is important so you can decide whether after-tax 401(k) contributions are the right choice for your retirement savings plan.

Potential Tax Implications

After-tax 401(k) contributions can come with certain tax implications, such as the taxation of investment earnings upon withdrawal. Additionally, you’ll need to track your after-tax contributions separately to avoid double taxation on your income.

Check with your plan administrator to see if they have a way to segregate your plan contributions by tax treatment. Ultimately, this makes the accounting easier down the road.

Limited Availability

Not all employer-sponsored 401(k) plans allow after-tax contributions, which may limit the availability of this option for some individuals. It’s crucial to check with your plan provider to determine if after-tax contributions to your traditional 401(k) are permitted.

Complexities in Managing After-Tax Contributions

Managing after-tax 401(k) contributions can be more complex than pre-tax or Roth contributions. They require separate tracking and potentially additional administrative tasks.

Careful recordkeeping and coordination with your plan provider are necessary to manage these contributions properly. You’ll need to monitor total contribution limits, taking into account employer contributions and your own elective deferrals into the plan.

Less Immediate Tax Relief

After-tax 401(k) contributions (made with after-tax dollars) do not provide immediate tax relief like pre-tax contributions. It’s essential to consider the trade-offs between the tax benefits of pre-tax and after-tax contributions when deciding how to proceed.

Potentially Higher Administrative Fees

After-tax 401(k) contributions may lead to higher administrative fees, such as the fees associated with in-service withdrawals or rollovers. Be sure to weigh these potential costs against the benefits of after-tax contributions when deciding whether this strategy is right for you.

Strategies to Maximize After-Tax 401(k) Contributions

In this section, we’ll provide an overview of various rollover and conversion strategies to help maximize the benefits of your after-tax 401(k) contributions.

Remember, it’s essential to understand your unique financial situation and retirement goals before implementing any strategy.

Mega Backdoor Roth

The Mega Backdoor Roth strategy involves making after-tax 401(k) contributions and converting these funds to a Roth account through an in-plan conversion. This strategy allows for tax-free growth and withdrawals in retirement.

Check with your plan administrator to see if they allow in-plan conversions.

Roth 401(k)

If your employer-sponsored plan offers a Roth 401(k) option, you may be able to roll over your after-tax 401(k) contributions into it. Roth 401(k) accounts offer tax-free growth and withdrawals in retirement.

Contributions to employer-sponsored Roth accounts won’t provide tax deductions in the same way that before-tax contributions to traditional 401(k)s will. But they can still be a very valuable tool in retirement, especially if you expect to face a high tax burden later in life.

Rollover IRA

Another strategy is to roll over with your Roth 401(k) into an IRA. This can help consolidate your retirement funds, simplify your account management, and increase your access to new investment options.

Be sure to properly track your after-tax contributions to avoid double taxation and ensure accurate reporting of these funds. This can be tricky if not done carefully, so proceed at your own risk.

Employer Match

Employer matching contributions play a significant role in maximizing retirement savings. Make sure to take full advantage of any employer match programs available to you. Then, consider allocating the entire account (including the employer match and after-tax contributions) to investments with high growth potential to maximize tax-deferred gains.

The Bottom Line: Making the Most of Your 401(k) Contributions

After-tax 401(k) contributions offer various benefits and drawbacks. Developing a personalized retirement savings strategy that considers your unique financial situation and goals is crucial.

Maximizing your total contributions (including employer matching contributions) can boost your long-run investment earnings and optimize your tax planning. Consult with a qualified financial advisor to determine the best approach for maximizing your after-tax 401(k) contributions.

If you’re looking to execute a 401(k) rollover, consider working with Capitalize. Our dedicated team can help you set up for retirement and ensure a financially secure future.