Maximize Your Retirement Savings: After-Tax Contributions to Your 401k

Saving from your earnings in a 401k plan is one of the most reliable ways to prepare for your retirement. It’s a tax-deferred plan set up through your employment, so you can contribute regularly, from each paycheck. There are limits to the amount that you can save, and contributions are usually made pre-tax. But did you know that you can increase the amount you save by also making after-tax contributions to your 401k?

How Money Gets Into a 401k

Most (but not all) employers facilitate 401k plans for their employees, so deferrals are usually made straight from your paycheck. These standard contributions are made before you pay tax, so they can have the effect of lowering your tax bill when it comes round each year. For example, if you earn $1000, and pay 10% into your 401k, you’ll only pay income tax on $900 of your earnings for that month.

Some employers may well offer additional contributions too, as they are encouraged to match or top-up your own contribution. They may offer a partial match plan, or a dollar-for-dollar match, up to a predefined limit.

One further option that some companies offer is a profit-sharing element to their 401k plans. They will apportion some of their pre-tax profit to their employees’ retirement accounts, either as a set amount or as a percentage of the employees’ salary. This works well for businesses because the amount they contribute to the 401k plans depends on the business’ overall financial success that year.

Limits apply as to how much you can make in pre-tax contributions to your 401k though – the IRS still needs to get its hands on some of your income, of course! For 2020 and 2021, employees can contribute up to $19,500. Anyone over the age of 50 who wants to make additional payments can – up to a value of $6,500 for 2020 and 2021. For 2021, the combined employer/employee maximum contribution has increased from $57,000 to $58,000.

Going Over the Regular Limits

If you’ve hit the limit for pre-tax employee contributions, depending on your 401k plan you may be able to make after-tax contributions. You’ll have to check with your employer to see if your plan will let you do this.

So let’s think hypothetically for a moment. Imagine you’ve contributed up to $19,500, and your employer matches dollar-for-dollar up to 4% of your salary, so they’re going to add $4,000 (assuming salary of $100,000) as well. That still leaves $33,500 (in 2020, or $34,500 if you’re planning ahead for 2021) that you could potentially add in after-tax contributions to your 401k. Profit sharing contributions also reduce this amount.

Now, with after-tax contributions, any earnings made on those ones will grow tax-free as long as they remain in the account. You could see some significant returns on those investments if they’re handled well.

After you retire and you come to withdraw money from your 401k, this is what it’s important to know:

  • Your pre-tax contributions will be taxed as ordinary income
  • Any earnings on your after-tax contributions will be taxed as ordinary income
  • The basis, i.e. your total after-tax contributions to your 401k will not be taxed again

After-tax Contributions to your 401k: A Supercharged Retirement Strategy?

As things currently stand, another option is to rollover those after-tax contributions, the basis, into a Roth IRA. You’ve already paid taxes on them, so you won’t pay taxes when you put them into either a Roth IRA or Designated Roth Account via an in-plan conversion. And then – you know this already, right? – you won’t pay taxes when you make withdrawals from a Roth IRA.

What about earnings on the after-tax amount? You just need to avoid a troublesome tax bill by moving after-tax earnings, along with pre-tax money (contributions, company match, and profit sharing) to a rollover IRA.

However, this is important: you need to remember that you must be at least 59.5 to make withdrawals from a Roth IRA, and your account must have been opened for at least five years. So if you want access to your money quickly, this isn’t going to be the right option for you.

The Mega Backdoor Roth Conversion

This can be an excellent way for high earners to make the most of a Roth IRA. After all, there are rules as to who can contribute to one directly. You need to be earning less than $136,000 (if you’re single) or $206,000 (married, filing jointly) to have one. However, higher earners can pay into their 401k, and then make what’s known as a backdoor Roth conversion by rolling their money over into a Roth IRA from their 401k.

And if you like things super-sized, you can do a mega backdoor Roth conversion by using these after-tax contributions. To do so, you’re going to need:

  • Plenty of money to save (i.e. more than the allowances mentioned above)
  • A 401k plan that allows after-tax contributions
  • A 401k plan that allows for in-service distributions to an IRA or siphoning off the after-tax contributions to an IRA

Make Sure You Get It Right!

Now, after-tax contributions to your 401k and the mega backdoor Roth conversions are excellent tax-advantaged strategies for your retirement savings. But, get it wrong and all of these moves could involve big tax bills. They’re complicated procedures and you need to make sure you’ve understood everything correctly and that you’re making rollovers at the right time.

If you’ve found yourself with more money to save and think that this could be a good strategy for you, please seek professional advice before committing to anything. We can help to look things over and make sure you’re going to be maximizing your savings, and not your tax bill. So if you’d like to talk through this or any other aspect of your retirement savings, please do give us a call.

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investing for retirement ebook ipad - McClain Lovejoy
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