A Guide on After-Tax 401(k) Contributions

The 401(k) is one of America’s most popular retirement plans. It has evolved over the years to offer greater flexibility to American workers, allowing them to save better for retirement. With each passing year, the number of companies offering their workers options to use their 401(k) retirement account has increased. If you find out that your 401(k) plan includes a choice that goes beyond the general 401(k) pre-tax contribution, then you should look further into the benefits associated with such a plan.
If given a choice, many American workers will opt for pre-tax contributions for their 401(k) plans as it helps them receive a lower federal tax bill for the year (in which they are made). Besides, one cannot discount the benefit of tax incentives from pre-tax contributions. To learn more about 401(k) plans, their benefits and how they can help you build a substantial retirement corpus, get in touch with a professional financial advisor.
But, you may also want to look into the option of after-tax contributions if you fall into the following categories:
- High-income earners
- Individuals looking for an emergency savings buffer
- Individuals who earn volatile incomes
You could also be a part of super-savers who have reached their 401(k) annual contribution limit and are now finding a home for additional retirement dollars. In such a case, you can put all those extra dollars in the 401(k) account as after-tax contributions. A 401(k) after-tax contribution is one where you put the additional money over and above the amount that you have already paid as taxes.
What are 401(k) contributions?
A 401(k) is an employee-sponsored workplace retirement plan that can help workers save taxes and plan for retirement by making regular contributions towards the plan. Employers match their employees’ contributions but only up to a certain threshold. Most workers choose pre-tax 401(k) contributions to save tax since they are not counted as taxable income. All the contributions grow tax-deferred till retirement, after which withdrawals are regarded as ordinary income, which attracts taxes.
Almost seventy percent of large and mid-size companies now offer their employees a Roth 401(k) account. If you wish to save for your retirement on an after-tax basis wherein your retirement withdrawals will not be taxed since you make contributions after paying taxes, then a Roth 401(k) account is your go-to option.
What are the benefits of after-tax 401(k) contributions?
An after-tax 401(k) can benefit workers in many ways such as:
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Acts as an emergency savings buffer
Several studies have shown that the majority of American workers live paycheck to paycheck and have very little left for savings. Hence, the slightest disruption in salary payments can make it difficult for Americans to manage their expenses. Thus, it is critical to build a reserve for emergency savings to mitigate the effects of unforeseen circumstances.
You can create an emergency fund in a convenient yet disciplined manner with the help of an after-tax 401(k) account. Such a fund will be helpful to cover unanticipated expenses without jeopardizing your retirement security (or attracting taxes and penalties). In case you end up not using the emergency savings, it becomes an additional source of long-term retirement savings. You can also withdraw your after-tax emergency savings if you need them, after conforming to certain rules and provisions. Generally, your contributions (except gains) are not taxed while withdrawing.
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Contribute over and above your maxed out 401(k) contribution limit
It is common for people who earn high incomes to reach their contribution limits quickly. Thus, having the option of after-tax 401(k) contributions helps them boost their retirement savings over and above the predetermined contribution limits. The 2022 pre-tax contribution limit is $20,500. If you fall under 50 and $27,000 if you are older than 50 years of age.
For instance, individuals less than 50 years old can contribute up to $61,000 in a 401(k) in 2022, and those older can contribute up to $67,500, given there are no objections from the employer. The mentioned figures include pre-tax, after-tax, employer, and Roth contributions. After-tax contributions allow you to benefit from continued tax deferrals on your income from capital gain, dividends, and interest on investments.
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Counteract the effect of volatile income
Individuals who have a volatile income can stand to benefit from the after-tax contributions. For instance, if you earn a commission-based income based on sales, you might make a good amount one year, but the commission might drop for the next year if the sales are not satisfactory. Due to this, they might not be able to maintain a consistent contribution over the years. The after-tax option allows such individuals to put higher contributions during periods of high income and ensure they have adequate retirement savings despite fluctuating income.
How to save taxes on after-tax 401(k) contributions
You must have realized the benefits of having after-tax contributions in your 401(k) account. However, all these contributions and earnings could be subject to tax when you start withdrawals during retirement. Hence, one needs to find ways to minimize their tax bill on their 401(k) savings.
You can save paying taxes on your after-tax 401(k) contributions by rolling them over into a Roth IRA account. This will allow you to prevent taxes on your earnings from contributions when you withdraw them. The contributions made into a Roth IRA are already taxed, and thus you are eligible to make tax-free withdrawals. There are some conditions to be fulfilled for getting such a benefit, like you need to be at least 59.5 years of age and must have started making contributions a minimum of five years ago.
Employers provide pension plans with benefits such as in-plan conversions and in-service withdrawals, which can help you save better. An in-plan conversion allows you to convert a portion of the total sum of your after-tax contribution amount into a Roth IRA. You will be required to pay taxes on the amount of money that you convert to a Roth, however, you will be able to make tax-free withdrawals provided you meet the conditions stated beforehand.
Sample plans offer an automatic conversion facility. If not in-plan conversion, your company might be providing in-service withdrawals and distributions under which you can withdraw money from your pension account while you are employed. Through this, you can make a contribution to a Roth IRA, which is not a part of your workplace retirement plan. If in-service withdrawals are not offered, you can research other ways of making withdrawals from your 401(k) without incurring any penalties.
Lastly, you can also split the after-tax contribution amount between a Roth IRA and a traditional IRA. The contribution can be put towards a traditional IRA, and the earnings on the investments can be put into a Roth IRA. Since after-tax contributions by definition imply contributions that are made after taxes have been deducted, no further taxes will be levied on them. The earnings, however, will be regarded as taxable income when withdrawing; hence shifting them into a Roth IRA will save taxes on those earnings.
We can understand this better with the help of an example. Let us assume that in 2021 you made an after-tax contribution of $20,000 to your 401(k). By the end of the year, you realize that you have earned $2,000. Now you can either choose to put the total sum of $22,000 into a Roth IRA and pay taxes on $2,000 or split the amount and transfer $20,000 into a Roth IRA and $2,000 in a traditional IRA. In such a way, you defer paying taxes on your earnings until you feel the need to withdraw during retirement.
Is an after-tax 401(k) plan the right choice for you?
Understanding the after-tax 401(k) plan is important to assess if it fits your specific requirements or not. The after-tax 401(k) can be especially beneficial if you are a high-income earner. You can still continue contributing to growing your savings even after maxing out the set contribution limits.
Another situation where an after-tax 401(k) option could help is if you wish to grow your investments tax-deferred, but would prefer not to open a brokerage account. Choosing an after-tax strategy allows the investor to gain tax-free compounding along with tax-free withdrawals during retirement. On the other hand, if he opens a brokerage account, you will be liable to pay at least some amount as capital gains tax when you sell appreciated assets.
If your employer does not provide in-plan conversions or in-service withdrawals, you decide not to do a rollover, then be careful before going for after-tax contributions. If you let your after-tax contributions grow in a tax-deferred 401(k) plan, you will be obligated to pay taxes on any earnings, once you start withdrawing from your account.
To conclude
Retirement planning is arguably the most important decision of one’s life. Hence it’s critical to comprehend the after-tax 401(k) plan to determine if it meets your individual needs. If you are a higher earner, an after-tax 401(k) can be extremely useful. Even if you’ve reached the maximum contribution limit, you can still contribute to and augment your savings.
After-tax strategies allow investors to benefit from tax-free compounding and tax-free withdrawals during retirement. Unless you are close to maxing out your retirement limit up to the pre-established limits, you should reconsider choosing an after-tax 401(k) contribution.
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