What Is an After-Tax 401(k) Contribution?
An after-tax 401k 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.
These additional contributions are made with after-tax dollars, and any gains on those investments will not be taxed until they are withdrawn from the account in retirement.
Your employer can choose whether or not to allow this type of contribution.
How Do After-Tax 401(K) Contributions Work?
After-tax 401k 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 401k 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 401k contributions.
Advantages of After-Tax 401(K) Contributions
Enables One to Put More Money Into the 401k Plan
For one who earns a high income and has already maxed out the pretax contribution limit for each year, making an after-tax 401k contribution is an advantage; it will increase the money that is being saved into the 401k plan.
Additional Tax-Deferral on Earnings
An after-tax contribution to a 401k account will mean that you will be taxed on the gains only once the money is withdrawn from your account.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You are only taxed on the money once it is being withdrawn from your account.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 401k 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 401k contributions although the taxes are not payable right away.
This may be fixed by rolling the funds over into a Roth 401k 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 401k 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 401k accounts.
You Have a Volatile Income Source
Say, for example, someone who earns on a commission basis has a 401k 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 401k contribution to cover for his needs while escaping from taxes and penalties.
The Bottom Line
After-tax 401k contributions make sense in certain situations such as when you have high income and want to save more money to the 401k 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 401k 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.
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®), 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.