There are multiple vehicles people can use to save for retirement and one of them is a 401(k). These workplace retirement accounts can be used to house pre-tax and after-tax dollars that can grow tax-deferred or tax-free until retirement. While 401(k)s usually have an annual employee contribution limit, the savings don’t have to stop there. People with more money they want to invest for retirement can use after-tax 401(k) contributions.
What Is an After Tax 401(k)
An after-tax 401(k) contribution is when you place post-tax dollars or dollars you’ve already paid taxes on into your 401(k) account. Since you’ve already paid taxes on the money, you cannot receive a tax deduction on these dollars. However, a major benefit of putting after-tax dollars into a 401(k) is that the money grows tax-free until you can withdraw during retirement. You can also withdraw contributions you’ve made without paying taxes or penalties.
It’s important to note that not every employer offers an after-tax 401(k), so check if it’s an accessible option.
Breaking Down the 401(k) Contribution Limit
401(k) accounts have an employee contribution limit of $23,000 in 2024, and those 50 and older can contribute an additional $7,500. However, there are other means by which funds can be added, including employer nonelective contributions, matching employer contributions, and after-tax dollars. This combined amount is considered the overall contribution limit. The overall contribution limit for a 401(k) is $69,000, or $76,500 if you’re 50-plus in 2024.
Pros and Cons of After Tax 401(k) Contributions
After-tax contributions can be a strategy for maximizing retirement savings, but they do have drawbacks. Here is a quick overview of the pros and cons.
Pros
- Allow high earners to save more for retirement.
- Can benefit from tax-deferred growth.
- Contributions (not earnings) can be withdrawn at any time tax and penalty-free.
- Can rollover after-tax dollars to an IRA.
- There are no income limits.
Cons
- Pay taxes when you withdraw earnings.
- Withdrawing earnings before 59 ½ could trigger 10% penalty.
- Rollovers to an IRA can be complicated.
- Limited investment options.
Minimizing Taxes on After-Tax 401(k) Contributions
Withdrawing after-tax 401(k) earnings is taxable, but it may be possible to minimize taxes by rolling after-tax dollars into an IRA. Two strategies in particular can be helpful.
Strategy 1: Roll all funds into a Roth IRA
One option to minimize taxes on after-tax 401(k) contributions is to roll all of those funds into a Roth. To roll after-tax contributions into a Roth, you typically need access to an in-plan conversion or an in-service withdrawal via an employer. Note that not every employer offers an in-plan conversion.
In-plan conversions allow you to convert after-tax contributions into a Roth and then pay taxes on the earnings, if any. People anticipating being in a higher tax bracket during retirement can now benefit from paying taxes on after-tax contribution earnings.
The benefit of rolling over into a Roth is enjoying tax-free withdrawals in the future as long as you don’t withdraw earnings before 59 ½ and meet the 5-year rule. Some 401(k) plans even have an auto-convert feature so that all after-tax dollars you contribute go straight into a Roth account. This can be beneficial as it leaves little room for earnings to accrue, meaning paying less or no taxes.
Another benefit of this strategy is you could potentially contribute more to a Roth than you could otherwise. In 2024, Roth contribution limits are $7,000 and $8,000 for individuals 50 and older.
Strategy 2: Split funds between a Traditional IRA and a Roth IRA
Another strategy is to split after-tax contributions between a Roth and a traditional IRA. With this option, after-tax contributions can be rolled into a Roth since you already paid taxes on them. The earnings, however, would go into a traditional IRA so they can grow tax-deferred, and you would delay paying taxes on that portion. However, you pay taxes on the earnings when you withdraw them. Also, keep in mind that it isn’t possible to only withdraw or convert contributions or just earnings-you must withdraw both.
For example, let’s say an individual contributed $20,000 after-tax dollars in 2023, and by 2024, they noticed that contribution earned $700 in interest, giving them a total of $20,700. Using this strategy, they could roll the initial $20,000 contribution they’ve already paid taxes on into a Roth IRA and would owe no taxes. The remaining $700 could go into a traditional IRA to delay the tax bill and allow that money to continue growing tax deferred.
After-tax contributions aren’t right for everyone’s financial goals, but they can be beneficial. Speak to one of our advisors today to see how it may fit into your retirement plan and investing goals.
