after-tax 401(k)

After-tax 401(k) contributions: Unlock the powerful savings

Easy to participate in, manage, and, hopefully, includes matching contributions from your employer – it’s no wonder the 401(k) has become the primary source of retirement income for the majority of retirees. Most are familiar with the traditional pre-tax and Roth contribution types, but few understand after-tax 401(k) contributions. Mysterious, confusing, and often disregarded, after-tax contributions are the secret weapon of the 401(k).

The caveat to using the little-known after-tax 401(k) contribution is that not every plan allows them. That’s the first step, check to see if you’re allowed to do so. Secondly, just because you can doesn’t mean you should. The after-tax contribution will only benefit you in specific situations. First, we need to set the 401(k) stage.

401(k) contribution types

Employees can make three types of 401(k) contributions, provided they’re allowed; pre-tax, Roth, and after-tax.

  1. Pre-tax: The most common, pre-tax contributions grow tax-deferred, but then all contributions, growth, and earnings are taxed at the time of withdrawal. Pre-tax deposits reduce your taxable income in the year you contribute.
  2. Roth: Most plans now allow Roth contributions, which are considered after-tax. They don’t reduce your taxable income in the year you contribute, but all Roth deposits, growth, and earnings not only grow tax-free, but are also not taxed at the time of distribution.
  3. After-tax: Some 401(k) plans allow additional after-tax contributions for employees who want to save extra above and beyond what they’re making in pre-tax or Roth contributions. The after-tax funds grow tax-deferred, and the contributions are not taxed at distribution (because they went in after-tax), but the earnings and growth, when withdrawn, are subject to tax.

401(k) contribution limits

For 2018, the annual contribution limit for employees who participate in a 401(k) is $18,500. Employees age 50 or older can take advantage of the catch-up provision and contribute an additional $6,000. Even if your 50th birthday isn’t until Dec. 31, 2018, you can make the extra $6,000 catch-up contribution for the year. That’s a total of $24,500 for those 50+.

That’s the most commonly discussed contribution limit, but there is another number (or two) you should know. The total contribution amount “from all sources” to a 401(k) for 2018 is $55,000 ($61,000 if you are 50+).

So which number is it?

$18,500, $24,500, $55,000, $61,000….whoa, easy with the numbers. It sounds confusing, but we’ll break it down. We’ll start with going over the phrase “from all sources.”

  • $18,500 Limit= Employee pre-tax + Roth contributions
  • $24,500 Limit (age 50+) = $18,500 Limit + $6,000 pre-tax/Roth employee catch-up contributions
  • $55,000 Limit = $18,500 Limit + employer contributions + after-tax contributions (if allowed)
  • $61,000 Limit = $24,500 Limit (age 50+) + employer contributions + after-tax contributions (if allowed)

Now for most of you, your company match + your contributions usually do not approach the limit of $55,000 or $61,000 (50+). That’s where the after-tax contribution comes in. Example time:

You’re 48, with a salary of $150,000 and you contribute the max, $18,500 ($9,500 pre-tax and $9,000 Roth) to your 401(k). Your employer matches 100% of your contributions up to 6% of your compensation, $9,000 ($150,000 x 6%). That’s a total of $27,500 (employee contribution $18,500 + $9,000 company match). Your 401(k) allows additional after-tax 401(k) contributions. The annual limit is $55,000 from all sources. You and your company are at $27,500. That leaves you the ability to save an additional $27,500 of after-tax contributions.

An extra $27,500 every year adds up quickly. Even if it’s an additional $10K, $5K, or even $1K, every extra dollar you save for retirement will make life easier down the road.

The secret weapon of after-tax 401(k) contributions

The super-secret weapon of the after-tax contribution is the ability to roll the funds into a Roth IRA without incurring any tax liability when you retire, move to another job, or if you’re allowed, take an in-service distribution. That’s right, even though these are not Roth 401(k) contributions, by being allowed to roll them into a Roth IRA they, in essence, become Roth contributions.

Ahhh, now it makes sense. The best number of all is the tax benefit of rolling the after-tax contributions to a Roth IRA as opposed to leaving them in the 401(k). The benefits to you are downright staggering.

  1. If left in the 401(k), the after-tax contribution earnings and growth get taxed as income when distributed. When, instead, they are rolled into a Roth IRA, they become tax-free distributions.
  2. There are no required minimum distributions (RMDs) at age 70½ in a Roth IRA. In a 401(k) ALL types of contributions (pre-tax, Roth, and after-tax) are subject to RMDs at age 70½. You can easily avoid the RMDs by rolling, not only the after-tax 401(k) amounts, but also the Roth 401(k) amounts to a Roth IRA.
  3. It may eliminate or reduce the need to make Roth conversions. After-tax 401(k) contributions give higher income earners greater access to Roth assets without the tax liability of a Roth conversion. Learn more about Roth Conversions here.

Just because you can, doesn’t mean you should

After-tax 401(k) contributions will only make sense for certain individuals, namely those who’ve exhausted the following:

Max out your pre-tax/Roth 401(k) contributions: Up to $18,500 ($24,500), which one, pre-tax or Roth, depends on your situation.

Max out your health savings account (HSA): If you’re a part of a high-deductible health care plan, it’s best to max an HSA out before the after-tax contributions. They too are contributed on a pre-tax basis and grow tax-free, but can be withdrawn tax-free to cover medical expenses. I love HSAs so much that in certain situations I recommend saving in an HSA ahead of maxing out the 401(k) Roth and pre-tax contributions.  Click this link to learn about 7 Ways An HSA Can Help You in Retirement.

The confusion between after-tax and Roth 401(k) contributions is understandable, but once you wrap your head around the tax differences, the decision on whether or not you should consider after-tax 401(k) contributions is quite simple. While not the first choice, after-tax 401(k) contributions, when available, are a slick way to supersize your Roth IRA and your tax-free retirement income.

Are after-tax 401(k) contributions available in your retirement plan? Do you have any questions or feedback you’d like to share? I’d love to hear your thoughts, so please feel free to leave a comment below so we can continue the discussion.


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