401(k) After-Tax Contributions
If you work at a company offering a 401(k) plan, you could defer $18,000 of pre-tax wages to the 401(k) plan ($24,000 if you are 50 or older). The advantage is that contributions are not included in your current income and, therefore, not taxed.
Let’s say you are a heavy saver and have deferred $18,000 of pre-tax income to your employer’s 401k. Many employers have a matching formula, meaning the employer will also contribute to your account. Based on a hypothetical matching formula, let’s assume your employer’s contribution is $10,000. In total, you now have $28,000 deposited to your 401(k) account for the year.
Did you know that the maximum amount of money that can be contributed to most 401(k) plans for 2017 is $54,000? In our hypothetical example, that means the employee could still put in an additional $26,000. This type of contribution is known as an after-tax contribution.
As a quick aside, an after-tax contribution is somewhat similar to a Roth 401(k) contribution, but there are important differences. The similarity between Roth 401(k) and an after-tax contribution is that the amount of the contribution is included in your income and you will pay taxes, today, on the contribution amount. The Roth 401(k) contribution will grow tax free, whereas after-tax contributions grow tax deferred (similar to your pre-tax contributions).
In the case of a 401(k) plan, tax free means you will never pay tax on the growth or the distribution. If growth is tax deferred, you will pay ordinary income tax once the money is withdrawn from the account.
After-tax contributions are not as popular because you have to pay tax on the contribution amount as it is included your gross income. There is also no employer match. And remember, that while your contributions are after-tax, the earnings of those contributions grow tax-deferred, not tax free like a Roth 401(k) contribution. Lastly, not all employer plans even allow for after-tax contributions. But, due to a recent IRS ruling, we may begin to see more plans allowing for after-tax contributions.
So what is the big advantage of after-tax contributions? After all, an investor could choose a regular taxable account instead of making an after-tax contribution. Tax-deferred earnings growth is the major reason, whereas you will probably receive a tax bill each year for the taxable account.
Another advantage is due to the recent IRS regulation. Let’s assume you separate from service (retire or quit) and decide to roll your 401(k) account balance to an IRA. You can now roll your after-tax contributions to a Roth IRA. From that point forward, the earnings growth and any future withdrawals will be tax free.
While having the availability of after-tax contributions is nice, it is not a panacea. Many investors’ will have a variety of accounts they can fund and must choose in what order to fund them.
For each person, based on their specific facts and circumstances, there is likely a preferred funding order they should choose. For example, if their employer matches contributions, the investor should likely contribute (either on a pre-tax or Roth basis) up to the employer matching limits. They may also choose to fully fund their 401(k) – even above what the employer will match.
Next, perhaps Roth IRA contributions would be appropriate since they would have both tax-free withdrawals and tax-free growth from day one. We generally think after-tax contributions should be one of the last components of an investor’s total savings contribution.
In our mobile society, where staying with a single employer is not common, using after-tax contributions could be a powerful way to get a higher level of Roth monies.
For example, a high-income younger person maxes out their 401k contribution, IRA’s, and also makes after-tax contributions. Assume that in three years they leave their employer to join another firm. At that point in time is when the after-tax contribution could become “full-fledged” Roth monies — assuming they are rolled to a Roth IRA. In this situation, the effect is a “delayed Roth” – you do not get the full benefit of tax-free growth until the funds have been rolled to the Roth IRA. But delayed Roth is better than no Roth.
Be aware that many employer plans do not accept after-tax 401(k) contributions. You will have to check with HR to determine if it is even available. If not, ask why not, and enlist your friends to lobby HR. Plan documents can be changed.
While making after-tax contributions may sound intriguing, most investors should also have taxable accounts to maintain sufficient short- and medium-term liquidity – that can be quickly and easily accessed.
Remember, the after-tax contributions are being deposited to a 401(k) plan and, as a result, are not easily accessible and should be viewed as retirement monies. In short, the assets cannot generally be converted to “quick cash”. That is one reason why a sufficient reserve fund (in a taxable account) needs to be available.
About the Author
Gregory A. Johnston, CFA®, CFP®, CPWA®, QPFC, AIF® has over 25 years of investment and comprehensive finanical planning experience. He started Johnston Investment Counsel in 1997 as an independent, fee-only investment management and comprehensive planning firm located in Peoria, Illinois. His clients include individuals, retirement plans, and endowments / foundations.