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Emily PraterFinancial AdvisorCPA, CFP®
After-tax 401(k) Contributions: Supercharge Your Retirement Savings
What are after-tax contributions?
Many employer 401(k) plans offer two contribution options: pre-tax and Roth. Pre-tax contributions are deducted from payroll, and the income is not subject to current taxation. Upon distribution in retirement, the original contribution amounts and any earnings are taxable. Roth contributions are treated as if the employee receives the compensation – even though the amounts are being invested in a retirement account – and are subject to current taxation. Upon distribution, earnings on the originally contributed amounts are not taxable.
Some plans offer a unique third option, the after-tax contribution. After-tax contributions are like a hybrid between pre-tax and Roth contributions. The contributions are made with income that is subject to current taxation (included in your W2 taxable wages), like a Roth contribution. The earnings on these contributions are subject to income taxes when distributed from the account, like pre-tax contributions.
How do they work?
After-tax contributions are most beneficial when an employee is already maxing out the annual elective deferral limit. The elective deferral or employee contribution limit is $22,500 in 2023. However, total 401(k) contributions are subject to a higher limit- $66,000. This amount consists of employee elective deferrals, employer matching and discretionary contributions, and after-tax contributions. An after-tax option within a plan allows high earners and super savers to put away more income into retirement accounts than the standard elective deferral amount.
After-tax contributions can be rolled into a plan’s Roth 401(k) or a Roth Individual Retirement Account (IRA). The earnings can be rolled into the pre-tax 401(k), a traditional IRA, or converted into a Roth 401(k)/Roth IRA. Converted earnings are included in taxable income in the year of conversion.
To best utilize after-tax contributions, individuals should roll out the contributions at least annually to minimize the taxable growth. Once rolled out to a Roth 401(k) or Roth IRA, any growth on the investments will not be subject to income tax upon distribution in retirement.
Pros
- The after-tax contribution option allows employees to supercharge retirement savings.
- After-tax contributions are subject to a higher annual limit than elective deferrals and Roth IRA contributions.
- Contributions can be kept in the 401(k) plan or rolled to an IRA. There is no separation of service nor age (59 ½) requirement.
- After-tax contributions provide a vehicle for high earners that are not eligible to make Roth IRA contributions to invest after-tax monies into retirement accounts.
Cons
- Earnings are taxable when distributed or converted.
- The onus of rolling out the contributions (and earnings) is on the employee. You must request a rollover from the plan administrator and specify the destination of the contributions and earnings.
- There is typically an administrative fee associated with the rollover.
- Contributions are included in taxable income, so there is no current tax benefit.
If you have questions about after-tax contributions and how to determine if your employer plan allows this type of contribution, please reach out to an advisor at Blue Chip Partners. We are here to help.
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