It’s no wonder the 401(k) has become the primary source of retirement income for the majority of retirees. It’s easy to participate in, manage, and there’s usually a matching contribution from your employer. 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 hurdle 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 after-tax 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.
- Pre-tax: These are 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.
- Roth: Most plans now allow Roth contributions, which are considered after-tax, meaning deferrals don’t reduce your taxable income. However, growth and earnings not only grow tax-free but are also not taxed at the time of distribution.
- 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and the contributions are not taxed at distribution (because they went in after-tax), but the earnings and growth, when withdrawn, are subject to tax.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 2021, the annual contribution limit for employees who participate in a 401(k) is $19,500. Employees age 50 or older can take advantage of the catch-up provision and contribute an additional $6,500. Even if your 50th birthday isn’t until Dec. 31, 2021, you can make the extra $6,500 catch-up contribution for the year. That’s a total of $26,000 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 2021 is $58,000 ($64,500 if you are 50+).
So which number is it?
$19,500, $26,000, $58,000, $64,500….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.”
- $19,500 Limit= Employee pre-tax + Roth contributions
- $26,000 Limit (age 50+) = $19,500 limit + $6,500 pre-tax + Roth employee catch-up contributions
- $58,000 Limit = $19,500 limit + employer contributions + after-tax contributions (if allowed)
- $64,500 Limit = $26,000 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 $58,000 or $64,500 (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, $19,500 ($10,500 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 $28,500 (employee contribution $19,500 + $9,000 company match). Your 401(k) allows additional after-tax 401(k) contributions. The annual limit is $58,000 from all sources. You and your company are at $28,500. That leaves you the ability to save an additional $29,500 of after-tax contributions.
An extra $29,500 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 secret weapon of the after-tax contribution is the ability to roll the after-tax 401(k) contributions into a Roth IRA without incurring any tax liability. This can be done when you retire, move to another job, or if you’re allowed, through an in-service distribution. Even though these are not Roth 401(k) contributions, by being allowed to roll them into a Roth IRA, they become Mega-Roth contributions. That’s right it doesn’t matter if it’s $4,000 or $400,000 of after-tax 401(k) contributons, you can roll the entire after-tax portion to a Roth.
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.
- 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.
- There are no required minimum distributions (RMDs) at age 72 in a Roth IRA. In a 401(k), ALL types of contributions (pre-tax, Roth, and after-tax) are subject to RMDs at age 72. 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.
- 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.
Solo 401(k) After-tax contributions
If you’re a small business entrepreneur, you can use after-tax contributions in your Solo 401(k). As the owner and boss, you can make contributions up to the limit of $58,000 or $64,500 (if 50+). Yes, you can roll those dollars over to a Roth IRA as well. In fact, the Solo 401(k) is one of the best places to use after-tax contributions. Learn more in It’s time you learn to effectively unleash the hidden potential of your Solo 401(k)
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: 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. However, 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? Don’t hesitate to contact us!