Aftertax 401k Contributions: Where They Make Sense
In the previous post, we’ve covered what you can expect from the Social Security program, depending on your age. Most of the younger investors we’ve spoken with inevitably concluded that they should be saving money via 401k-plan pre-tax deductions, where available through their employers. But we’ve gotten a number of questions about aftertax 401k contributions, which generally make sense for a small subset of the population.
The reason for the uptick in interest is because the option to make this type of contribution has been added to more and more plans following a change in IRS regulations in 2015. To figure out whether an aftertax 401k makes sense, we need to know whether you’re maxing out your 401k already. If you're not putting the full $18,000 (or $24,000 for those above 50) into it, you don't have any reason to make aftertax contributions to the plan because they will always be less effective than pretax and Roth contributions.
There are three types of 401k contributions that employees can make: pretax, Roth, and aftertax. Pretax and Roth are subject to the annual limits of $18,000 (under age 50) and $24,000 (over 50). There is also a higher limit of $54,000 that applies to all contributions, including employer-matching contributions, non-vested assets of employees who have left the plan, and aftertax contributions.
If an employee contributes $18,000 to 401k, the amount can start compounding immediately, and compounding is tax-deferred. When the investor begins withdrawing in retirement, the entire withdrawal is taxed at her ordinary income tax rate. The tax treatment of Roth 401k is exactly the opposite. The employee puts in money that has already been taxed, but withdrawals in retirement are tax-free. The money compounds on a tax-free basis, and the big payoff comes when she retires, since all withdrawals are tax-free.
So what’s the difference between Roth 401k and aftertax contributions? Both involve aftertax money, but the key difference is that the person who makes Roth 401k contributions enjoys tax-free compounding immediately, and withdrawals of the whole balance will be tax-free. By contrast, the aftertax 401k contributions are subject to tax-deferred compounding. When those funds are eventually withdrawn, they'll be taxed as ordinary income. So if you choose to make aftertax 401k contributions, you’ll get taxed twice: first you’ll pay the income tax, and then the appreciation tax.
So why would anyone bother with aftertax contributions? The benefit of the aftertax 401k comes in only after someone has maxed out the contribution limit ($18,000 for people below 50 years of age), contributed to an IRA, and still has excess money to invest for retirement. For such investors, the main benefit comes in when they are able to get the aftertax 401k assets out of the plan and rolled over into a Roth IRA, where they can begin compounding tax-free. Also, wealthy investors don’t need to worry about not fully using Roth assets, since they can be passed on to heirs. For affluent investors and job-hoppers who can get their aftertax 401k assets into a Roth IRA while they're still working, the aftertax 401k can be particularly appealing.