A Guide To After Tax 401k ContributionsSubmitted by Castlebar Asset Management on December 3rd, 2015
After tax 401k contributions have been a source of confusion for most people who can contribute to a 401k plan. It used to be tricky how to handle after tax 401k contributions once you leave your company or retire. There are now clear rules in place which make this process simple.
Individuals in their 30’s and 40’s who have contributed a fixed percentage of your income into your 401k's may be bumping up against the maximize pretax contribution limits of $18,500 (2018 levels) as your salary has increased. Your 401k plan has to allow after tax contrition in order to go over the $18,500 limit. Currently, about 42% of plans allow after tax contributions. If your 401k allows additional contributions the maximum you can contribute including your pretax contributions, your after tax contributions and your employers match is $55,000 (again a 2018 level).
The IRS has offered a ruling which clarifies what happens to your after tax contributions. You can roll any after tax contributions directly into a Roth IRA thanks to the ruling made clear by the IRS for 2015. This actually can only take place once you leave your current employer or retire. In the past it was murky on what to do with after tax contributions and in some cases you would have had to pay taxes in order to roll it into a Roth IRA. Thankfully this is not the case anymore!
Who should use after tax contributions:
For someone in their 30’s and 40’s after tax contributions are smart if you would like to contribute more to a Roth plan but your company does not offer a Roth 401k or you earn too much to meet the income requirement for a Roth IRA. After tax contributions are a great way to supersize your retirement contribution. Whether you are playing catch up if you are a late starter saving for retirement or you are planning to retire early this is a strategy that could work for you. Remember you can’t withdraw money from a 401k or Roth IRA prior to 59.5 unless certain criteria are meet.
After tax contributions are intelligent if you are planning on passing money onto future generations. Since your after tax contributions can be rolled over into a Roth IRA it can be an efficient way to pass money on when you pass away. You don’t have to withdraw or take a required minimum distribution from a Roth IRA you will be able to pass this money onto your heirs.
One final thing to consider is if you or your spouse’s 401k stinks. I have seen 401k's that offer no match and only expensive fund options. In this case if you or your spouse has a good 401k plan that offers a matching contribution above the $18,500 pretax contribution limit you could consider concentrating both of your contributions in one plan. You won’t get all of the immediate tax benefits today but this would assist in saving for retirement and give you access to a Roth IRA in retirement.
Only about 6% of people are contributing on an after tax basis. This is usually reserved to higher income individuals but it can be a great strategy to save for retirement and get the benefits from Roth IRA in retirement.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.