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What is an "After-Tax 401(k) Contribution" and Should I Be Doing It?

Saving money for retirement is always a wise decision. If you contribute to a 401(k), you’re already making great strides to protect and grow your money for the future. However, even after you reach your annual contribution limits, you may find yourself with extra cash that you aren’t sure what to do with. 

There’s good news. Your standard 401(k) contribution limits don’t have to stop you from getting even more tax-advantaged savings, allowing you to responsibly save even more for retirement. In fact, if you’ve maxed out your annual contribution limit, you can still take advantage of an after-tax 401(k) contribution.

What is an After-Tax 401(k) Contribution?

After-tax 401(k) contributions are simply that - money put into your 401(k) after taxes have been paid on it. These are not the same as Roth contributions to your workplace savings plan. The earnings in Roth 401(k) contributions are ultimately tax-free dollars, while earnings attributed to after-tax contributions are considered tax-deferred. While the 2021 401(k) contribution limit is $19,500 for those under 50, you can still put more money into your 401(k) each year after taxes, up to $58,000. 

For high-income earners, this is a welcome benefit. If you have extra cash after standard retirement saving, you will want to make that money work for you instead of just leaving it sitting in your savings account. In fact, you can even make these after-tax contributions at the same time as your regular contributions, instead of waiting until you’ve maxed them out. 

Note: When you withdraw money from a 401(k), it will be taxed as regular income as long as it is from your pre-tax contributions. However, withdrawals of after-taxed contributions are not taxed, but their earnings, which grow tax-deferred until withdrawals begin, would be taxed as regular income. 

What should you do with your after-tax 401(k) contributions? Well, there are several options.

Convert Your After-Tax 401(k) Contributions to a Roth Account

Converting after-tax 401(k) contributions to a Roth account is an option to manage your tax burden in retirement. After converting to a Roth, earnings can grow and be distributed tax-free if certain requirements are met. This is sometimes referred to as a mega-backdoor Roth IRA contribution.

When you leave a job, you can also roll after-tax money from your workplace 401(k) into a Roth IRA. When you do that, you should roll EARNINGS of those after-tax contributions to a Traditional IRA….and then convert those earnings to your Roth IRA over time.

Rolling over after-tax money:

Taking out just the after-tax balance would not be allowed. When you roll over after-tax money to a Roth IRA, your earnings on the after-tax balance must be rolled over as well. You cannot withdraw your after-tax contributions without also withdrawing their earnings. You may need to roll out any other pre-tax money also, depending on your plan.

Rolling over pre-tax money:

When you roll over a pre-tax balance into a traditional IRA it is not considered taxable. It is important to note that any partial rollover of after-tax contributions including earnings must be in equal proportion to their levels in the plan where you worked.

Always consult a tax professional on these strategies as it will require some number crunching to make sure everything is being done right. You don’t want to lose other potential tax advantages, including possible early withdrawal exemptions net unrealized appreciation for employer stock.

Convert Earnings on Your After-Tax 401(k) Contributions to a Roth IRA

While converting your after-tax contributions into a Roth account is a good strategy for tax-deferred growth, it bears repeating that the earnings on those contributions are treated differently. Under normal circumstances, they would be taxed. However, you can circumvent that by rolling your after-tax earnings on those contributions into a traditional IRA. You can then convert that IRA to a Roth IRA over time. This allows you to spread the tax hit over a period of years and perhaps avoid being bumped into a higher tax bracket in any one year.

Withdraw Your Money, If Your Plan Allows In-Service Distributions, and Convert It to a Roth IRA

Once you’ve saved the $19,500, you can save into after-tax 401(k) bucket all the way up to that $58,000 limit and then either convert to the Roth 401(k) if your plan allows it, or eventually, withdraw the money and convert to a Roth IRA once distributions are allowed in your plan. Under normal circumstances, this happens after you are 59 ½ years old and the account is at least five years old. However, each plan document is unique and has a unique set of rules covering what is and isn’t allowed in that particular plan.. Consult your plan administrator for a complete set of rules on what might be allowed in your particular plan. 

It is important to note that with all the strategies mentioned above, there are always potential limits or rules allowing or prohibiting certain strategies. Before converting any funds to other accounts, consult your workplace retirement investment plan to determine what’s possible for your specific situation. Also, always reference the IRS to determine what’s allowed with your plan. 

If you earn a high income and are planning for retirement, there are few places you can protect your money from being lost to taxes. Continuing to contribute to your 401(k) after you’ve reached your contribution limit is a great strategy to do just that. By following our advice with after-tax 401(k) options and subsequent Roth conversions, you’ll save a lot more for retirement without being subject to income limits.

While it can seem complicated, it’s well worth the effort to take advantage of these strategies. Talk to a financial professional today to discover how you can maximize your retirement savings and set yourself for a brighter future.