Understanding After-Tax 401(k) Contributions and Their Benefits

While the 401(k) retirement account is an effective option for saving for your golden years, it comes with some limitations, the primary one being the contribution limits. Traditional 401(k) contributions are made from your pre-tax income and are subject to annual contribution limits. The after-tax 401(k) offers an alternative for contributing more to your 401(k) per annum and enjoying tax-advantaged growth at the same time.

A financial advisor can help you understand more about making 401(k) after-tax contributions and how you can use the after-tax account to boost your retirement savings. This article will also discuss how an after-tax 401(k) account can be beneficial to maximize your savings by cutting down on tax.

Understanding the after-tax 401(k) account

An after-tax 401(k) is a type of retirement savings account that allows you to contribute money that has already been taxed into your 401(k) account. This differs from a traditional 401(k) plan, where your contributions are made pre-tax, and Roth 401(k) plans, where contributions are made post-tax but offer tax-free withdrawals in retirement.

The Internal Revenue Service (IRS) sets contribution limits for the 401(k) every year. In 2024, the annual limit for a traditional 401(k) is $23,000 if you are under the age of 50. Investors aged 50 and above can make an additional catch-up contribution of $7,500 as per the 401(k) 2024 contribution limit set by the IRS for people over 50, bringing their total to $30,500. An after-tax 401(k) allows you to bypass these limits. While your contributions are made with after-tax dollars, they are not subject to the $23,000 limit. Instead, after-tax contributions fall under the overall limit for plan contributions, which in 2024 is $69,000 or $76,500 for those aged 50 and older, including any employer matches.

Here is an example to help you understand how this works:

Imagine a scenario where you earn $90,000 annually and have been diligently contributing to your 401(k) account. In 2024, you took full advantage of the opportunity and contributed the maximum allowed amount of $23,000. Your employer offered a matching contribution of a 100% match up to 5% of your annual salary and contributed an additional $4,500 into your 401(k) account.

Now, you have a total of $27,500 in your 401(k). However, the overall annual 401(k) limit for 2024 is $69,000, and you still have room to maximize your contributions. If your employer’s 401(k) plan permits after-tax contributions, you can further use this opportunity to boost your retirement savings. With $27,500 already invested in contributions, you can allocate an additional $41,500 in after-tax dollars to your 401(k) account. This additional contribution will not only enhance your retirement nest egg but also provide you with valuable tax advantages.

There are often debates about after-tax 401(k) vs Roth 401(k). However, it is essential to note that an after-tax 401(k) is not the same as a Roth 401(k). When it comes to retirement savings, both after-tax 401(k) contributions and Roth 401(k) contributions involve paying taxes upfront, but they have significant differences in terms of contribution limits, tax treatment, and withdrawal rules.

An after-tax 401(k) allows you to make higher contributions compared to a 401(k) plan, making it ideal for additional tax-advantaged savings. As explained above, in 2024, you can contribute up to $23,000 to a 401(k) in employee contributions, with an extra $7,500 catch-up contribution available for those aged 50 and older. This limit applies to a Roth and a traditional 401(k). However, an after-tax 401(k) limit is much higher as it lets you make a total contribution of up to $69,000 or $76,500 for those 50 and older, including employer matches. This is because contributions made to an after-tax 401(k) are not considered elective deferrals and, therefore, do not count towards the $23,000 limit. Instead, they are subject to the overall limit on plan contributions, allowing for higher total contributions.

In the case of a Roth 401(k), once the contributions are made, they grow tax-free. You do not pay taxes on withdrawals during retirement, provided you meet the qualified distribution requirements and make withdrawals after the age of 59.5. This means that both your contributions and investment earnings can be withdrawn tax-free. However, with an after-tax 401(k) account, your contributions are also made with after-tax dollars, so they do not lower your taxable income in the year you make them. However, unlike Roth contributions, the earnings on after-tax contributions are taxed as your ordinary income for the year when withdrawn in retirement. To understand after-tax 401(k) withdrawal rules in retirement, you need to look at two components separately – the contributions and the earnings. While you can withdraw your contributions tax-free, the earnings component of the withdrawal will be taxed as ordinary income in the future.

Benefits of using an after-tax 401(k) account

1. Offers tax-advantaged growth on your investment

A significant benefit of using an after-tax 401(k) account is the tax-advantaged growth on your contributions. The after-tax 401(k) allows your contributions to grow on a tax-deferred basis. As a result, when you withdraw money in retirement, you are taxed only on the earnings, while your contributions remain tax-free. Any investment earnings generated by your contributions within the account are not subject to immediate taxation. Instead, they can grow and compound over time. This allows your retirement savings to potentially grow more quickly. This unique feature can significantly enhance your retirement savings potential over the years.

2. Opens doors to multiple kinds of investors, including those with fluctuating and high incomes

Contributing to a retirement account regularly can be particularly hard for people with unsteady incomes. However, an after-tax 401(k) account offers you the flexibility to accommodate your contributions as per your income. While the 401(k) offers high contribution limits, you may not always be able to maximize your contributions if your income changes from month to month. With a 401(k), you can contribute much less in years when your income is lower. However, during higher earning years, you can contribute more than the standard $23,000 limit, plus an additional $7,500 catch-up contribution if you are aged 50 or older. The account’s flexibility allows you to take advantage of after-tax contributions to save more in a tax-advantaged vehicle and bolster your retirement savings when you have the financial capacity to do so.

After-tax contributions in a 401(k) plan can be particularly advantageous for individuals in higher income and tax brackets. Unlike traditional IRAs, after-tax 401(k) plans do not have income limits. Regardless of your income level, you can contribute to an after-tax 401(k) plan if your employer offers it. The absence of income limits ensures that individuals with higher incomes can still take advantage of the benefits of after-tax contributions. After-tax contributions allow you to effectively reduce your taxable income in the current year, thereby potentially lowering your overall tax liability. Contributing to after-tax 401(k) accounts will enable you to take advantage of tax-deferred growth opportunities. Any investment profits that you earn within the account grow tax-free until retirement. This provides you with an opportunity for substantial wealth accumulation over time. And if you fall in a higher tax bracket, the after-tax contributions can be helpful for tax diversification. You can diversify your retirement savings and contribute to both pre-tax and after-tax accounts to create a tax-efficient source of retirement income, especially if you may be in a lower tax bracket in retirement than you are now.

3. Provides the option to switch to a new 401(k) or an Individual Retirement Account (IRA)

If you quit your job and move to a new employer, you can transfer your existing 401(k) to a new employer and continue contributing to the plan. The same can be done with an after-tax 401(k) as well. If your new employer offers an after-tax 401(k), you can transfer your existing after-tax 401(k) funds to a new employer’s retirement plan or to another eligible retirement account. This ensures that all your retirement savings are consolidated in one place, and you continue investing without any hiccups. Moreover, you also stay in control of your retirement savings. Leaving your old accounts with the previous employer can result in neglected savings. However, moving to the new employer’s plan makes it easier to manage your savings and make use of the new plan’s investment options.

You can also opt to roll over your after-tax contributions into an IRA or another qualified retirement plan. Rolling over to a Roth IRA involves transferring your after-tax contributions to a Roth IRA. You can use this option in case of a job change or even while you are still employed with the same company. An IRA rollover offers several benefits, including tax-free growth potential, tax-free withdrawals in retirement, diversification, and more.

4. Offers flexibility on withdrawals

Another great advantage of making 401(k) after-tax contributions is the flexibility they offer in terms of withdrawals. Unlike traditional core 401(k) plans that have a penalty on withdrawals made before the age of 59.5 years, after-tax contributions can be withdrawn at any time. Typically, your contributions can be withdrawn tax-free. So, you have the flexibility to tap into your after-tax contributions whenever needed without facing immediate tax consequences or penalties.

An after-tax account provides you with the freedom to access your contributions without having to worry about withdrawal rules. This increased liquidity makes it an ideal option for an emergency fund. After-tax contributions can be withdrawn tax-free, which makes them suitable for addressing unexpected financial needs, such as healthcare expenses, home repairs, and other urgent needs. You can build this emergency fund with regular and disciplined savings at your workplace and cater to two financial goals at the same time – establishing your emergency savings and creating a retirement nest egg.

However, you must keep in mind that only your contributions are tax-free. Any gains that you earn will be taxed. So, while your tax liability is reduced, it is not entirely eliminated.

To conclude

With higher post-tax 401(k) contribution limits, the appeal of the account is evident. You can use an after-tax 401(k) to enhance your retirement nest egg, save more every year, and maximize your tax-advantaged savings while enjoying financial liquidity. The flexible rules, higher contribution limits, appeal for high-income groups, and greater tax benefits make the after-tax 401(k) a great retirement investment strategy. However, it is essential to discuss its availability with your employer and consult a financial advisor to determine if this plan is suitable for your needs.

Use the free advisor match tool to get matched with seasoned financial advisors who specialize in retirement planning and get professional assistance in making the right decision. Answer a few simple questions based on your financial needs, and the match tool can help you find 1 to 3 financial advisors who are best suited to help you.

For further information on creating a suitable retirement plan for your unique financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.