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Sunday, May 19, 2024

What’s the difference between after-tax contributions to a 401(k) plan vs. Roth 401(k)?

What’s the difference between after-tax contributions to a 401(k) plan vs. Roth 401(k)?

06.30.2023

Many employers in the United States offer a 401(k) plan to help employees save for retirement. When you set up your account,  you may have the choice between different types of contributions. In recent years, Roth contributions have become especially popular. While they don’t provide any immediate tax deductions, the after-tax contributions potentially grow and compound tax-free translating to tax-free retirement withdrawals in the future as long as certain conditions are met.                                                                                   

In addition to pre-tax and Roth 401(k) contributions, some providers offer the ability to make after-tax contributions to the 401(k) plan. At first glance, you might think Roth 401(k) and after-tax contributions are the same thing since both contributions are made with after-tax dollars. Though, in reality, there are a few key differences between the two that are important to understand.

Roth contributions

When you contribute to a Roth 401(k), your contributions are made after taxes, meaning you can’t deduct them to reduce your taxable income, nor do they come out of your paycheck before taxes. The good news is that if used correctly, once the funds are in your 401(k), you’ll never pay taxes on them again. Your investments  offer tax-free growth potential while they’re in the account, and you can make tax-free withdrawals during retirement as long as certain conditions are met.

Roth contributions are subject to many of the same limitations as traditional pre-tax 401(k) contributions. For example, workers can contribute up to $22,500 in 2023, with an additional catch-up contribution of $6,500 allowed for workers ages 50 and older. Of course, your employer can also contribute to your account in an employer match, for a total contribution limit that’s even higher.

Because of the powerful tax benefits, it’s no surprise the Roth 401(k) has become such a popular tool for today’s workers. After all, after paying taxes at the time you earn the income, you’ll never pay taxes on  these investments again as long as you meet the withdrawal requirements. Because the tax burden falls at the time you make the contribution (unlike traditional pre-tax 401(k) contributions, where the tax burden happens at withdrawal), they’re especially popular with workers earlier in their careers and those who expect to be in a higher tax rate during retirement.

After-tax contributions

After-tax contributions to a 401(k) plan are similar to Roth contributions in that they’re made with after-tax dollars, and don’t reduce your taxable income in the year you make them. But unlike with Roth contributions, after-tax contributions aren’t subject to the $22,500 limit.

Unlike traditional and Roth 401(k) contributions, after-tax contributions aren’t considered “deferrals”. As a result, instead of being subject to the $22,500 limit on elective deferrals, they’re subject to the overall limit on plan contributions, which, in 2023, is $66,000 (which may be lower for highly compensated employees in some cases to allow the plan to comply with IRS non-discrimination requirements).

The tax treatment of after-tax contributions comes with a catch. Unlike with Roth contributions, your withdrawals during retirement aren’t tax-free. Instead, your investment gains at the time of withdrawal will be taxed as ordinary income. This is different than a traditional pre-tax 401(k), where all withdrawals — both contributions and earnings — are taxed as ordinary income at withdrawal.

You might be wondering why someone would choose a contribution type that requires them to pay taxes both when they contribute to and withdraw from their account. If your plan allows, the after-tax contribution option should be considered only after contributing the annual limit to your traditional pre-tax or Roth 401(k). If you’re able to participate, there’s a provision in the tax law that allows after-tax contributions to be converted to Roth contributions. Since you’ve already paid taxes on the contributions, the conversion would only require that you pay taxes on any earnings that are converted. As such, it may be advantageous to periodically move after-tax contributions out of the 401(k) plan if allowed, and it’s advisable to consider engaging a tax advisor or CPA to help you navigate this strategy successfully.              

Making sense of it all

 In the table below, we’ve identified some of the most important features of both Roth and after-tax contributions:

 

Roth 401(k)

After-tax contributions

Taxes on contributions

Contributions are made after-tax

Contributions are made after-tax

Taxes on withdrawals

Withdrawals are tax-free as long as withdrawal requirements are met

Withdrawals are taxed as ordinary income (earnings only)

2023 contribution limits

$22,500

$66,000

Rollover

Contributions can be rolled over into a Roth IRA

Contributions can be rolled over into a Roth IRA

 

Roth contributions have become increasingly popular among workers, since they allow for tax-free potential investment growth and tax-free withdrawals as long as you meet the withdrawal requirements. For many people, Roth 401(k) contributions may be a good choice if you expect to be in a lower income bracket in retirement.                                              

But what if you’re a high-earner who wants to save more than $22,500 per year in a tax-advantaged account? In that case, you might be better off deferring the $22,500 to a traditional 401(k) and contributing additional savings as an after-tax contribution to the 401(k) plan. You still enjoy some of the tax advantages that come with a Roth IRA, but with a potentially considerably higher contribution limit.                                   

In addition to higher earners, other people who may enjoy this after-tax benefit are those with a fluctuating income. It’s possible that during certain years, the amount you can save for retirement is lower. But in other years, you’re able to save more than the $22,500 limit. In that case, you can use after-tax contributions to save more in a tax advantaged vehicle.

The possible downside of the after-tax contribution is the tax treatment of withdrawals during retirement. The good news is some plans allow you to convert your after-tax funds to Roth funds using an in- plan conversion or a rollover to a Roth IRA.

Ultimately, both Roth and after-tax contributions to 401(k) plans can be valuable tools to supplement income, tax-free, in retirement.

  • Your income and the amount you can save each year will be the major determining factor in whether Roth or after-tax contributions are right for you.
  • If you can save $22,500 or less and expect to be in a lower tax bracket in retirement, then the Roth 401(k) could be a great option.
  • If you want to and can afford to save more than that, you may want to consider making after-tax contributions to your 401(k) plan if allowed.                 

You may want to consider talking to a financial professional for more detailed guidance on your retirement saving strategies.

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