What You Need to Know About After-Tax 401K Contributions

Most employees with a traditional 401(k) plan through their employer make regular contributions deducted directly from their paychecks. The amount you can contribute every year is capped; for example, in 2022, the cap is $20,500, with an additional $6,500 in catch-up savings allowed for workers 50 and older.

Employers often match a certain percentage of your contribution to help you grow your savings, and the total amount of your and your employer’s contributions is also capped. In 2022, the overall annual limit for 401(k) contributions, including those from you and your employer, is $61,000.

But what if your total contributions don’t reach this yearly limit? That’s where after-tax 401(k) contributions come into play.

How After-Tax 401(k) Contributions Work

Vanguard’s How America Saves 2021 report states that only 10% of people with access to after-tax 401(k) contributions use them, and those who do tend to be high-income earners. If you’re a high earner, after-tax contributions may be beneficial because after-tax 401(k) contributions do not have income restrictions like a Roth IRA.

Let’s look at an example.

Say you earn $100,000 annually and contribute to a 401(k) through work, maxing out your annual contribution in 2021 by saving $19,500. If your employer offers a 100% match of up to 6% of your yearly salary, they contribute an additional $6,000. So, you now have $25,500 in your 401(k).

In 2021, the overall annual limit for 401(k) contributions was $58,000. If you only contributed $25,500 overall and your employer’s plan allows for after-tax 401(k) contributions, you can contribute up $32,500 more in after-tax dollars before you reach the yearly cap.

Benefits and Strategies for After-Tax Contributions

Using 401(k) after-tax contributions is especially beneficial for those in higher tax brackets. You can withdraw any after-tax contributions without paying as many penalties. That said, if you withdraw from these contributions when you’re younger than 59 ½, you may have to pay a 10% penalty.

Taxes are another thing to consider. Any earnings you make from after-tax contributions are taxable.

Putting Contributions into a Roth IRA

To ensure you get tax-free withdrawals during retirement, consider putting your after-tax 401(k) contributions into a Roth IRA. Just keep in mind that you will have to wait until you are 59 ½ to withdraw, and you must make your first contribution before you are 54 ½.

If you are interested in making after-tax contributions, there are two ways to do so. (Note that not every company offers after-tax 401(k) contributions, so check with your employer or HR representative to see what is available.)

The first strategy is called an in-plan conversion. With this option, you can easily convert some or all of your retirement savings into a Roth account. You pay taxes on the money you convert but not on future withdrawals. Some plans may even offer auto-conversion so you can do this quickly and easily.

The other option is an in-service withdrawal. With this approach, you can roll your after-tax savings into a Roth IRA not connected to your employer-sponsored retirement plan.

If your employer doesn’t offer in-service distributions or in-plan withdrawals, you may have to ask what options you have to withdraw money and put it into an IRA and what the risks and penalties are.

Split Between a Roth and Traditional IRA to Defer Taxes

To avoid paying taxes on the earnings of any after-tax contributions, you can put your after-tax savings into a Roth IRA and your earnings into a traditional IRA. By splitting your contributions in this way, you will end up paying taxes on your earnings when you make a withdrawal from your traditional IRA.

Here’s an example. Say you made $20,000 in after-tax contributions to your 401(k) in 2020. When you check your balance at the end of the quarter, you realize you made $1,000.

Now, you can either roll the $21,000 into a Roth IRA, paying taxes on the $1,000, or put the $20,000 into a Roth IRA and the $1,000 into a traditional IRA. If you split your savings, you won’t pay taxes on the $1,000 until you withdraw it from your traditional IRA when you retire.

Are After-Tax Contributions Worth It for Me?

Here are some people who should consider making after-tax 401(k) contributions:

• High earners who have maxed out their pre-tax contributions. After-tax contributions may be an excellent way to boost your savings.
• Anyone who wants to grow tax-deferred investments without a brokerage account. After-tax 401(k) investments might be better because they are a little more tax-efficient. You get tax-free compounding with tax-free withdrawals in retirement. With a brokerage account, you will pay capital gains taxes when you sell your securities.
• People who can’t do a rollover because their employers don’t offer in-service distributions or in-plan conversions. Think carefully here, though. If you let after-tax contributions grow in your 401(k), you will have to pay taxes when you withdraw your earnings.

After-tax contributions aren’t suitable for everyone and aren’t worth considering unless you’re already making the maximum allowable contributions to your 401(k). Pre-tax contributions are better than after-tax contributions from a tax standpoint.

Final Thoughts

After-tax 401(k) contributions aren’t for everyone, but if you want to build an emergency savings account or are a high-income earner who has maxed out your total pre-tax contributions and has more money to invest, after-tax contributions are a good option.

Note that employers may not match after-tax contributions, so check the details of your employer-sponsored plan and talk to your financial advisor about how these options affect your personal circumstances.

Any opinions are those of Thomas Fleishel and not necessarily those of Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

 Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

 401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.

 Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.

 Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.