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A Simple Guide to After-Tax 401(k) Contributions Thumbnail

A Simple Guide to After-Tax 401(k) Contributions

Many 401(k) plans these days offer the ability to contribute above and beyond the maximum annual limit ($19,500 in 2020) by utilizing an after-tax account. As of 2015, about 48% of all 401(k) plans offered this feature, but many plan participants are unaware of its existence or just don't understand it. Yet, for those already maxing out all other retirement accounts, the after-tax portion of a 401(k) provides an excellent vehicle for additional retirement savings. Despite the name, however, after-tax contributions are not Roth contributions. In fact, the rules are somewhat different than both pre-tax and Roth contributions, so it's essential to familiarize yourself with how to use an account of this nature before making contributions. Fortunately, we've cut through the noise for you in this simple guide on after-tax 401(k) contributions.

The Back Story

401(k) plans are not that old, believe it or not. In fact, they were almost created by accident. 

In 1978, Congress passed the Revenue Act of 1978, which included a provision - Section 401(k) -  that was added to the Internal Revenue Code to allow employees to avoid being taxed on deferred compensation. Then in 1980, the first 401(k) plan was created by Ted Benna (a benefits consultant at the time) in his quest to find ways to design more tax-friendly retirement programs for a client. 

Benna had the idea of allowing employees to save pre-tax money into a retirement plan while receiving an employer match. Unfortunately, though, his client did not approve of this idea, so Mr. Benna implemented the first 401(k) plan at his own company, the Johnson Companies, instead. 

In 1981, the IRS then issued new rules allowing employees to fund their 401(k) through payroll deductions, thereby kicking off the modern 401(k) as we know it today.

Pre-Tax Contributions

With pre-tax contributions, money is deducted from your paycheck before taxes are calculated.

As a result, pre-tax contributions reduce your overall taxable income. That money in your 401(k) then grows tax-deferred, meaning you don't pay taxes on it until you take funds out of the account. As per IRS rules, pre-tax contributions are not accessible until age 59 ½. All distributions taken from pre-tax accounts are subject to ordinary income tax, regardless of your age. 

However, if the distribution is taken before turning age 59 1/2, it is also subject to a 10% penalty unless you also qualify for a hardship distribution. For 2020, the most you can contribute pre-tax to your 401(k) is $19,500 ($26,000 if 50 or older). In general, pre-tax contributions make the most sense when your tax rate is 28% or higher since it's likely to be lower in retirement.

Roth Contributions

In the early 2000s, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 that included a provision modeled after the Roth IRA, creating the Roth 401(k). 

The Roth portion of your 401(k) works just like a Roth IRA in that the contributions are made with after-tax money. You receive no tax deduction on contributions, but you don't have to pay taxes either on qualified distributions and the funds grow tax-free. There are some significant differences between a Roth 401(k) and a Roth IRA, however.

For one, there are no income limits on Roth 401(k) contributions. 

Secondly, a Roth 401(k) is subject to the much higher $19,500 ($26,000 if age 50 or older) contribution limit for a 401(k), as opposed to only $6,500 ($7,500 if age 50 or older) for IRA's for 2020. 

Thirdly, a Roth 401(k) does not allow you to access your original contributions at any time like a Roth IRA does. Instead, the Roth 401(k) requires you to attain age 59 ½ or have the Designated Roth account for at least five years, whichever comes later. 

Finally, a Roth 401(k) mandates required minimum distributions once you reach age 70 ½, unlike Roth IRA's which do not. In general, Roth 401(k) contributions make the most sense when your tax rate is 24% or lower since it's likely to be higher in retirement. 

How After-Tax 401(k) Contributions Differ

Most people confuse 'after-tax contributions' with Roth contributions. While they're similar, they are not the same. 

After-tax contributions are similar to Roths in that they are both made with after-tax dollars, but they vary on the back end. 

In a Roth, contributions grow tax-free and are tax-free upon withdrawal. 

In an after-tax account, contributions grow tax-deferred, and investment earnings are subject to ordinary income taxes upon withdrawal. After-tax contributions can also be made after you've already maxed out your 401(k). 

For 2020 you can contribute up to an additional $37,500 to an after-tax 401(k) to meet the $57,000 total maximum allowed, which includes all contributions made between both the employee elective deferrals and the employer matches. 

As a simple example, assume you make $200,000 per year, max out your 401(k) this year at $19,500 and your employer matches at 6% for an additional $12,000, you could contribute an additional $25,500 for the year ($57,000 - $19,500 - $12,000 = $25,500) to your after-tax account.

The Roth Rollover

One of the significant pitfalls of after-tax 401(k)'s is the fact that they're taxed at ordinary income rates twice - once before contributing and once again upon withdrawal. 

This fact isn't very appealing when you could just as quickly put money in a taxable account instead. In a taxable account, there are no contribution limits, and you have access to long-term capital gains tax rates. Fortunately, there is a workaround.

IRS Notice 2014-54 now allows for what's known as a 'mega backdoor Roth’ contribution. This is where you make after-tax 401(k) contributions and immediately convert them to a Roth within the 401(k) itself. 

In essence, the mega backdoor Roth makes it possible to make after-tax contributions, but not pay ordinary income taxes on the investment earnings, nor pay any ordinary income taxes on the conversion itself.

Before the IRS issued Notice 2014-54, the rules surrounding the execution of this type of Roth conversion were quite tricky and confusing. Now, however, anybody can take advantage of the mega backdoor Roth if their 401(k) allows for it. 

If your 401(k) does not allow for in-plan conversions, you can still convert after-tax funds to a Roth, but only upon separation of employment. The investment earnings in the after-tax account will also be subject to ordinary income taxes upon conversion.

As a result, it's always a good idea to check with your employer or 401(k) plan administrator to get all the specifics on how they treat after-tax contributions. Some plans make it easy for you and will let you set up immediate automatic Roth conversions of the funds once they are contributed. 

Other plans, however, may only allow you to convert quarterly or at different intervals. In those instances, you'll want to hold the funds in cash until you can convert to a Roth so you avoid paying ordinary income tax on any earnings achieved beforehand.   

The Bottom Line

After-tax 401(k) contributions and their Roth conversion power provide excellent means for stocking away more tax-advantaged money for retirement. However, we recommend you always do your homework before making contributions. 

Employers have a lot of control and flexibility in how they structure and design their plans, particularly the after-tax portions. Understanding the rules and requirements of your plan will help you avoid any unexpected or adverse tax consequences.

Securities and Advisory Services offered through Calton & Associates, Inc., dba Forefront Wealth Partners, Member FINRA/SIPC. OSJ: 2701 N. Rocky Point Drive, Suite 1000, Tampa, FL 33607 (813) 264-0440. Calton & Associates, Inc. does not provide legal or tax advice. Forefront Wealth Partners and Calton & Associates, Inc. are separate entities.