The 401(k) has become synonymous with retirement. It’s the primary type of account used to save for retirement in today’s corporate world. Most are aware of the tax benefits a traditional 401(k) provides along with often generous “matching contributions” made by employers to encourage saving. However, one potentially overlooked 401(k) option by both employers and employees are after-tax 401(k)’s. This article will discuss the basics of after-tax 401(k)’s, when to utilize this account, and how to complete the “mega back door Roth” contribution.
Basics of After-Tax 401(k)’s
1. Unique Tax Benefits
After-tax 401(k)’s are not to be confused with Roth 401(k)’s. Although they share similar tax benefits, they’re not entirely the same. Roth 401(k)’s have the added benefit of the entirety of the account balance growing tax-free. Meaning, when it’s time to ultimately make withdrawals from a Roth 401(k), given the owner is not subject to an early withdrawal penalty, there are zero taxes owed.
In contrast, after-tax 401(k)s grow tax-free, but when withdrawals are made, taxes are owed in the earnings portion of the account but not on contributions. Lastly, the pre-tax 401(k) would owe taxes on the entirety of the withdrawn amount. The after-tax falls in the middle of the spectrum within 401(k)’s for tax treatment.
2. Higher Contribution Limits
After-tax 401(k)’s are not subject to the 2020 federal maximum of $19,500. Instead, they’re subject to the overall plan maximum of $57,000. Meaning, if you’ve maxed out your traditional or Roth 401(k) contributions at 19,500, you’re still able to contribute up to $37,500 to the after-tax account! Keep in mind; you must also account for employer contributions for this maximum. If your employer contributed 9k to your 401(k) as a matching contribution, the total amount you can add to the after-tax account is lessened by that amount.
Regardless, the additional contributions that can be made to an after-tax account are incredibly high and extremely beneficial for high-income earners looking to stash away more tax advantageous investment funds.
3. In Plan Roth Conversions
To truly maximize after-tax 401(k) contributions, you’ll want to see whether your plan allows “in-plan Roth conversions.” If so, setting up an automated conversion from your after-tax 401(k) account to the Roth 401(k) account immediately after contributions are made each pay period can result in substantial tax benefits over the long-term. Remember, the Roth 401(k) grows completely tax-free, whereas the after-tax 401(k)’s earnings are eventually taxed upon withdrawal. However, if you convert the contribution to the after-tax 401(k) immediately, the earnings from that contribution are minimal or potentially negligible. Therefore you won’t owe any taxes on that amount, and when you eventually withdraw from the Roth account, zero taxes are owed!
When to utilize an After-tax 401(k)?
Even if your employer offers an after-tax 401(k), it doesn’t always make sense to contribute. For example, you’ll want to ensure you max out the traditional or Roth 401(k) first before dipping into the after-tax account. The traditional and Roth 401(k)’s offer superior tax benefits without any additional legwork. If the contributions to those accounts are first met, then you may consider utilizing the after-tax 401(k).
That being said, always view your finances from a holistic standpoint. If you’ve done a great job getting funds into retirement accounts but not want to focus on purchasing a home or starting a family. It may make sense to send those extra funds elsewhere, where they’re more accessible for other near term goals.
How to Complete the “Mega Back Door Roth” Contribution
The mega back door Roth is a fancy way of describing the aforementioned in-plan Roth conversion from an after-tax 401(k). If you’ve looked to increase retirement savings in the past in the form of using the “back door Roth IRA,” then you’ll love the “mega back door Roth” strategy. To rehash, the back door Roth IRA is a strategic way to get funds into a Roth IRA regardless of income. The IRS states that once your income is above a certain level, contributions can’t be made directly to the Roth IRA. Luckily, the IRS has “blessed” the strategy of first making contributions to an IRA and then converting it to the Roth IRA. Ensuring that the entirety of the contribution then grows tax-free.
The same process applies to the mega back door Roth, but with much larger contribution limits. As previously mentioned, that contribution could be as high as $37,500 in additional savings. The contribution is first made to the after-tax account, the in-plan Roth conversion is initiated, and the funds are converted to the Roth bucket of the 401(k). Again, this guarantees superior tax treatment over the long-term by getting the funds into the Roth account as opposed to the after-tax account.
Other Key Points
There are a few pitfalls to be aware of before utilizing an after-tax 401(k) and/or initiating the mega back door Roth. First, if you’ve already established an after-tax account and accumulated a relatively significant balance, ensure you review what the tax consequences will be if you convert the balance to a Roth. Remember, the EARNINGS portion of the after-tax account will be realized as income if converted to a Roth account. Therefore, if the account has significant earnings, prepare to have a tax liability and/or review whether it makes sense in the first place.
Secondly, determine how much “extra” you want to set aside in retirement accounts. If you’ve determined you have an extra 6k to set aside, you may be better off using IRA’s and completing the “back door Roth IRA” strategy instead. If you want more control over your investments and reduced fees, the IRA’s are typically a better place to start with additional retirement savings. If you have additional room for savings above this amount, then you could look towards the after-tax contributions.
The Bottom Line
After-tax 401(k)’s are a growing feature to many employers retirement plans. Understanding the potential long-term benefits of utilizing it can substantially increase retirement savings and potentially help prepare for a “better” retirement. Of course, ensuring you’re checking all the boxes before implementing this relatively complex strategy is key. If you have questions about your employers after-tax 401(k) or need assistance in determining whether you should contribute, schedule a free consultation today!
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. Levi’s been quoted in the New York Times, Business Insider, Forbes, and is a frequent contributor to Investopedia. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!