Wondering if you should make an after-tax contribution to your 401(k) this year? You are hardly alone in your question.
These after-tax contributions don’t save you money on your taxes the way pre-tax contributions to your 401(k) do, so why is this even something worth considering?
Well, for starters you may have already maxed out all your pre-tax contribution limits. If that’s the case, after-tax contributions are still available to you. Or, you may want to keep emergency savings in an after-tax account so you can be saving toward retirement but also have access to your principal contributions without penalty in case of an emergency.
Making contributions to an after-tax 401(k) can make good sense for some people. Here is why the limits are so significant in 2022.
1. Fully Maxing Out Your Retirement Contributions
Maxing out your retirement contributions is a way for you to ensure you’ll have enough income in retirement. The more you save and the more time you have to save before you retire can contribute significantly to your financial outlook.
But, you may not be able to reach the cap with your 401(k) contribution and employer match alone.
You can contribute up to $20,500 in your traditional 401(k) in 2022. If your contribution, plus any employer match you get, doesn’t add up to the overall annual limit — $61,000 in 2022 — you may be able to make after-tax contributions to your 401(k) to get to that amount.
This is significant because it means that you can actually contribute much more to your retirement savings than you may think. And if you have extra cash and aren’t sure where to put it, this is one way to make smart use of your money.RELATED CONTENT: What is an "After-Tax 401(k) Contribution" and Should I Be Doing It?
2. Diversifying Your Tax Liability in Retirement
Part of any “good” financial plan entails tax planning as well. When you retire, you ideally want different buckets of retirement income - some that are taxable and some that are not. The reason for this is so that you can hedge against a rising tax environment later and anticipate inflation. Also, the way our tax brackets work is that the income you take first hits the lower tax brackets (i.e. 0%, 10%, and 12%) first, and then once you graduate to the 22% tax bracket, that 22% rate ONLY applies to the dollars you earn in and above that tax threshold!
By having money in after-tax and Roth 401(k) buckets, you have a second pool of resources to pull from so that you can keep your effective tax rate as low as possible in retirement.
Also, when you make an after-tax 401(k) contribution, you can grow your investments tax-deferred.
Like a Roth 401(k), an after-tax 401(k) contribution is made after taxes are paid. Like a Roth 401(k), earnings grow tax-deferred. However, unlike a Roth 401(k), the earnings on the account are taxed upon withdrawal. Therefore, you will only pay taxes on the growth.
Of course, if you have access to a Roth 401(k) account, this may be a better account worth contributing to so that you don’t wind up needing to pay taxes on the growth. But Roth contributions are limited to the $20,500 amount while after-tax contributions can then be made up to the higher $61,000 defined contribution maximum limit.
3. Converting After-Tax 401(k) Retirement Savings to a Roth
Are there any opportunities to NOT have to pay taxes on the growth of your after-tax 401(k) earnings? YES!
If your plan allows for in-service conversions, you may be able to convert the whole amount of your after-tax 401(k) contributions to your Roth 401(k) or Roth IRA by what is known as a Mega Backdoor Roth Conversion!
While this tax loophole has been a topic of discussion under the Biden administration, nothing has been done thus far to disallow these conversions. Will 2022 be the last year to take advantage of this and get more money into your Roth 401(k)? Potentially! Take advantage of the opportunity to convert these after-tax 401(k) dollars to Roth 401(k) dollars if your plan allows for it while you are still employed.
In this way, you can pay your taxes now and then allow your retirement account to continue growing, tax-free, until you retire.
Word of Caution
As with any major financial decision, determining how much to save into which types of retirement accounts isn’t something you need to do alone. It is always a good idea to discuss your personal financial situation and opportunities with your financial advisor and tax specialists. Knowing what to expect from any specific action on your retirement accounts beforehand is highly advisable.
For instance, if you were to convert your Traditional 401(k) to a Roth 401(k), you would need to make sure you have the money now to pay the taxes. Maybe you can’t do it all at once and so you plan to do it over a longer time horizon.
Talk to your financial advisor as you have questions about the best choices you can make for your financial life. He or she should be able to help guide you through important decisions like these ones.