Investigate the pros and cons of making ‘after-tax 401(k) contributions.‘
American workers now have more options for their retirement savings thanks to the 401(k)’s over the past few decades. Suppose you are fortunate enough to work for a company that offers options beyond the standard pre-tax contribution, such as after-tax 401(k) contributions. In that case, you should carefully consider how you maximize your financial security in retirement.
The majority of American workers, when given the option, choose to make pre-tax contributions, also known as conventional contributions, which reduce their federal income tax liability in the year the donation is made. After-tax contributions, which are distinct from Roth 401(k) contributions, may be more advantageous financially if you fall into one of the three categories below, even if the tax incentive for pre-tax contributions is an obvious immediate benefit:
- People whose earnings are highly unpredictable.
- Those who do not have a savings cushion in case of an unexpected expense.
- Those with high incomes make the most of their pre-tax contributions.
Following a brief overview of 401(k)s, we’ll dive deep into each of those three cases.
Intro to 401(k)s: Some Historical Context
Over eight in ten big and medium-sized businesses now provide their employees with a Roth 401(k) option, giving them a choice to pay taxes and withdraw their money tax-free in retirement.
Individuals can take advantage of tax breaks when saving for retirement by participating in a 401(k) plan at their place of employment. Payroll deductions are used to collect employee contributions; some employers may match such payments to a particular percentage. Most 401(k) contributions are made before taxes are taken off. As 401(k) contributions are not taxable, an employee’s pre-tax contributions can help them pay less in taxes during the current tax year. While these funds grow tax-free while the employee is employed, they are subject to ordinary income taxation upon withdrawal.
After-Tax 401(k) vs. Roth 401(k)
In reality, only approximately 21% of businesses even allow for after-tax contributions. A 401(k) contribution that is “after-tax” is one that is made after taxes have already been paid, similar to a Roth 401(k). Earnings increase tax-deferred, much like a Roth 401(k). However, the profits on the account are subject to taxation when withdrawn, unlike a Roth 401(k). It was available long before the Roth 401(k) was created (k). The Roth 401(k) is better if you want to save for retirement after taxes have already been paid. If you aren’t required to pay them, there’s no point.
While this line of thought may lead employees to overlook the after-tax 401(k) contribution option entirely, they may want to reconsider for the following three reasons:
Your first and foremost justification should be that you should have some savings set up for unexpected events.
We’ve all seen the numbers showing that Americans collapse under even the tiniest income shock. More than half of all Americans are forced to live from paycheck to paycheck, and 35% of the population spends more than they bring in each month, according to a report on consumer trends from 2021. These grim numbers emphasize the critical importance of Americans establishing a rainy-day fund.
You can set up a dedicated emergency fund at work in a tax-deferred 401(k) account, which can be straightforward and disciplined. You can use this fund to pay unexpected needs to avoid jeopardizing your retirement savings, incurring a tax charge, and perhaps incurring early withdrawal penalties. If you don’t need the emergency fund, it can be used for long-term goals like retirement. If you save for emergencies from your after-tax income, you will have quick and easy access to those funds, subject to any withdrawal limits imposed by the plan. Withdrawals of contributions (but not earnings) are generally tax-free at any time.
If a Roth 401(k) is so advantageous, what’s the point of a traditional 401(k)? While contributions to both types of plans are made using after-tax dollars, the rules for withdrawing funds from a Roth 401(k) are more stringent, and early withdrawal penalties kick in if you are under the age of 5912.
Tips for investing your 401(k) emergency fund: If you save for unexpected expenses using your 401(k)’s option, remember to invest the money conservatively. This is because you’d like to guarantee that the funds set aside for emergencies are still available if and when you need them, and riskier investments, like stock funds, can and make experience losses. Contributions to your 401(k) plan for retirement savings can be invested conservatively, moderately, or aggressively depending on your age and risk tolerance level.
Note that if you take profits (but not contributions) from your emergency savings before age 59 1/2, you will be subject to a 10% penalty in addition to ordinary income taxes on the earnings.
Thus, it’s best to play it safe with your investments. With the assurance that you can always get to your emergency fund if needed, you may feel more confident investing the rest of your retirement savings more aggressively.
With a 401(k) emergency fund, you can put all your savings in one place and take advantage of payroll deductions simultaneously. Access to your funds is not an issue, unlike with a standard or a Roth 401(k).
Two, you’ve already contributed as much as you can before taxes, and you make a lot of money.
If you have a high income and want to deposit the maximum to your 401(k) in 2023 (up to $22,500 if you’re under 50 or $30,000 if you’re 50 or older), then making after-tax contributions may be the most financially prudent option. Should your company offers a 401(k) plan, you can contribute up to $66,000 in 2020 if you’re under 50. The total would incorporate employee and employer contributions, regardless of tax status. Those aged 50 and up are subject to a $73,500 cap. Suppose your maximum pre-tax 401(k) contribution has been met. In that case, you can continue to delay taxes on investment income such as dividends, capital gains, and interest by making after-tax contributions to your plan.
Some persons may make additional contributions to switch to a Roth IRA later. In retirement, “tax diversity,” or having both Roth and pre-tax assets, can be beneficial since it gives you more options for earning income in a tax-efficient manner, both now and in the future.
With an in-plan conversion, several retirement plans enable account holders to move pre-tax 401(k) funds into a tax-deferred Roth 401(k) account. You can switch to a Roth IRA if your plan doesn’t offer this option after you leave your job.
Alternatively, you can roll your after-tax contributions into a Roth IRA after leaving your employment and your after-tax returns on those contributions into a regular IRA at the same time if you are not prepared to pay all the taxes that would be owed. A traditional IRA can be converted to a Roth IRA in the future. As a result, you can spread the tax burden over a more extended period and avoid being pushed into a higher income tax rate in any given year.
Fact #3: You Can’t Depend on a Stable Income.
For people whose salaries fluctuate frequently, it may make sense to establish a savings cushion in an after-tax account. A person in a commission-based sales profession could save quite a bit one year but only a fraction the following year if times are tough. If your income changes over time, you can still put away enough for retirement by contributing more to an after-tax account during years when it’s higher.
Contributions to a 401(k) Plan After Taxes
Not everyone will benefit from making 401(k) contributions after taxes. On the other hand, after-tax 401(k) contributions may make sense if you have a high income but have already contributed the maximum to your traditional pre-tax and Roth 401(k) and still have money to invest. This is because after-tax contributions are not subject to federal income tax. Employer plans are restricted from providing a matching contribution to a Roth IRA or other post-tax account.