A traditional 401(k) plan allows you to make tax-deferred contributions to the account. Your 401(k) plan might also allow for after-tax contributions, which enable you to save more for retirement. However, there are restrictions to be aware of. Contributing after-tax dollars to a 401(k) account can present certain opportunities and potential disadvantages.
When considering an after-tax 401(k) contribution, you’ll want to know:
— An after-tax 401(k) contribution allows you to deposit more than the $22,500 pre-tax limit for 2023 ($30,000 at age 50 or older).
— The total 401(k) contribution limit that includes employer and employee contributions and after-tax 401(k) contributions is $66,000 in 2023 ($73,500 at age 50 or older).
[Read: New 401(k) Contribution Limits for 2023]
What Is an After-Tax 401(k) Contribution?
After-tax 401(k) contributions refer to funds that are added to the plan after income tax has been applied. In 2023, the tax-deferred contribution limit for a traditional 401(k) is $22,500 and $30,000 for those who are 50 and older. When you put in these dollars, you defer paying income tax on this income and the investment earnings it generates over time. When you withdraw funds during retirement, they will be subject to taxes.
If you decide to contribute more than the tax-deferred 401(k) limit, the funds will be taxed as income in the year you make the contribution. The total contribution limit in 2023, including pre-tax and after-tax contributions, is $66,000 or $73,500 if you are at least age 50. “For most people, the company match and employee contributions do not approach the limit of $66,000 or $73,500 (for those who are 50 or older),” says Jim White, founder of Great Oak Wealth Management in Pottstown, Pennsylvania. “That’s where the after-tax contribution comes in.”
How After-Tax 401(k) Contributions Work
Not all employers permit after-tax contributions to traditional 401(k) plans. For plans that allow for the extra amount, “there could be the possibility to significantly increase 401(k) contributions through after-tax contributions to get you to the $66,000 or $73,500 max,” White says.
You won’t get an immediate tax break on the after-tax dollars that you contribute to a 401(k) plan. “With after-tax contributions, the earnings will get taxed when taken out in retirement, but your contributions will never get taxed (again),” says Jamieson Hopp, a financial planner at Millennial Wealth in Seattle.
[READ: How Much Should You Contribute to a 401(k)?]
The Benefits of After-Tax 401(k) Contributions
If you have already maxed out your tax-deferred contribution limit, making an after-tax contribution creates an opportunity to save more. Companies that allow for after-tax contributions may also make it possible to carry out Roth conversions. “Some 401(k) plans allow you to take out these contributions as cash without penalty,” says Brian Dudley, a senior vice president at Wealth Enhancement Group in Burlington, Massachusetts. “If your plan allows this, you can do a mega backdoor Roth, which is where you roll after-tax contributions into an IRA outside of your retirement plan.”
Higher earners may use this planning tool to fund a Roth account. “A 401(k) has no income restrictions on after-tax contributions, but a Roth outside does,” Dudley says. “If you contribute funds to your after-tax account and then almost immediately distribute those funds via an in-service distribution to an outside established Roth IRA, you remove the income limit and put a large amount of savings into a Roth account.” In a Roth account, the growth is tax-free, and so are the distributions if certain criteria are met.
[Read: How to Take Advantage of 401(k) Catch-Up Contributions.]
The Drawbacks of After-Tax 401(k) Contributions
If you find it difficult to meet the $22,500 contribution limit in your 401(k), it could be hard to save an additional amount. You might need to first increase your income and then contribute more. You may also decide to look for ways to rework your budget and prioritize retirement planning.
If you can make the after-tax contribution, you’ll still have to pay income taxes on the dollars that you deposit. You may decide to review other savings options to see if another type of investment creates tax savings or other advantages.
How to Tell if After-Tax 401(k) Contributions Are Right for You
Evaluate how much you have put into your 401(k) plan during the past year or more. “When you make pre-tax contributions to your 401(k), you are able to reduce your taxable income for the current year,” Dudley says. For this reason, if you are able to contribute up to the limit of $22,500 (or $30,000 if you are 50 or older), it’s often wise to do so. “This can be beneficial because it can lower the amount of taxes you owe for that year,” Dudley says. If your employer offers a 401(k) match, you’ll have additional funds to put into your long-term savings.
After this step, if you’re looking to save more, ask if the after-tax contribution is available for your 401(k) plan. “The limits of how much you can contribute after-tax might vary across plans,” Dudley says. You may also want to see if the IRA rollover is an option.
In addition, consider other investments and accounts. You could qualify for tax incentives to contribute to a health savings account or Roth IRA.
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How to Make After-Tax 401(k) Contributions originally appeared on usnews.com
