After-Tax 401(k) Contribution
An after-tax 401(k) contribution is a money that an employee contributes to his/her retirement account in addition to the pre-tax amount and the employer’s match.
Your employer can choose whether or not to allow this type of contribution.
How Do After-Tax 401(k) Contributions Work?
After-tax 401(k)contributions do not earn a tax deduction.
Since these contributions taken from your paycheck have already been taxed, all investment earnings from these contributions will be tax-free.
When a plan holder withdraws from a 401(k) account, the portion of the after-tax contribution will not be taxed while the pretax contributions will need to be taxed at the time of withdrawal.
Note that not all employers allow after-tax 401(k) contributions.
Advantages of After-Tax 401(k) Contributions
Enables One to Put More Money Into the 401(k) Plan
For one who earns a high income and has already maxed out the pretax contribution limit for each year, making an after-tax 401(k) contribution is an advantage; it will increase the money that is being saved into the 401(k) plan.
Additional Tax-Deferral on Earnings
An after-tax contribution to a 401(k) account will mean that you will be taxed on the gains only once the money is withdrawn from your account.
Since you already paid tax on the contribution, and then invest it, and pay no more taxes until you withdraw the monies at retirement, this increases how much money can grow tax-free.
If you have an emergency, after-tax contributions can provide you with a “cushion” of cash that is not taxed.
You are only taxed on the money once it is being withdrawn from your account.
An after-tax 401(k) contribution can also serve as a savings buffer against future taxes.
Not only does this give you more money to invest, but you are taxed at your ordinary income rate when withdrawing this money at retirement, regardless of how long it has been in the account.
Disadvantages of After-Tax 401(k) Contributions
Employers who allow after-tax contributions will not make a tax deduction for these amounts as they would for the pretax contributions.
Owing Taxes on Your Earnings
This is one of the biggest disadvantages of after-tax 401(k) contributions although the taxes are not payable right away.
This may be fixed by rolling the funds over into a Roth 401(k) or IRA.
Funds will have to be separated into different components which is a bit of a headache in calculating the amount of tax that needs to be paid.
When Will After-Tax Contributions Be a Good Idea?
With all its complexity and other disadvantages, after-tax contributions still make sense in some situations such as these:
Increasing Your Emergency Savings
Because after-tax 401(k) contributions are not any more subject to tax when withdrawn, it will be a good place to keep some extra savings for emergency use.
If you have exhausted your emergency savings at the time of retirement, accessing this money is not any more difficult than making a withdrawal from an ordinary account.
Putting Aside Extra Cash for Future Taxes
You can maximize the amount of after-tax contributions in order to save more money in tax deferral if you are expecting to owe taxes when you retire.
You Have High Earnings
You can set aside more money for retirement when you are done maxing out the limits for pretax contributions to 401(k) accounts.
You Have a Volatile Income Source
Say, for example, someone who earns on a commission basis has a 401(k) account. In times when his income is high, after-tax contributions will allow him to save up for the rainy days ahead. On years when income has been low, he may take out some portion of the after-tax 401(k) contribution to cover for his needs while escaping from taxes and penalties.
The Bottom Line
After-tax 401(k) contributions make sense in certain situations such as when you have high income and want to save more money to the 401(k) account, or when you have volatile income and want to play with its tax-free advantages.
If you are considering making after-tax contributions to your 401(k) plan, make sure that you fully understand how it works and all the implications of having money in this account.
Once you have exhausted all other opportunities for tax-deferred investments, using after-tax contributions may be a good choice.
Reaching out to a financial advisor will always be a good move so that a finance professional can actually help you in making the most out of your decisions.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.