The Planner's Perspective: After-Tax Should Not Be An Afterthought
By Paul Morrone CFP®, CPA/PFS, MSA
You’ve inevitably heard someone say that the ‘maximum contribution’ to a 401(k) plan is $18,500 if under 50 and $24,500 if over 50 (for 2018). This is a bit misleading, however, as the maximum total addition to a defined contribution plan is actually $55,000 for the 2018 tax year, of which the above limits apply only to pre-tax salary deferrals. Confused yet? Many times, people don’t even know they have after-tax money in their 401(k) plan until they try to roll out the balance and the representative on the phone tells them that they have after-tax contributions as well. This little ‘surprise’ often leads to the question ‘where did this money come from?’
It could have come from many places, as many employer plans do allow for additional after-tax contributions. While common, it is not a mandatory provision required by ERISA, a federal regulation governing retirement plans, hence why only some plans offer the benefit. Before getting too excited about a chance to save more money, it may be best to confirm with your employer as to whether after-tax contributions are allowable.
For argument’s sake, let’s assume that your plan does allow for these types of contributions and that you aren’t limited as a highly compensated employee. Let’s also assume that you are currently depositing $18,500 to your plan and your employer makes a matching contribution of $10,000. If, using our example, you defer $18,500 and your employer contributes $10,000, you have effectively deposited $28,500 to your plan for the year, an amount well below the $55,000 overall limitation. How does it work?
In short, the key is understanding the concept of ‘maximum total additions’ to the plan. Notice that we’re not specifying pre-tax money, after-tax money or employer match funds. Think of this simply as ‘total deposits’ to your account during the year. Under these assumptions, you would be eligible to contribute another $26,500 into the plan each year! Now if you’re asking yourself if you’ve been missing out all of these years, the answer could be yes or no.
Taking our example a bit further, let’s assume you continue at this pace for 10 years, at which point you would have made $265,000 in after-tax contributions to the plan in addition to your pre-tax deferrals and employer match. If those $265,000 generate $100,000 in profits over the 10-year period, you will ultimately have $265,000 in after-tax money and an additional $100,000 (the hypothetical earnings) in pretax money that remains part of your pretax 401k balance (with your other pretax funds and employer contributions).
The real power of the after-tax contributions comes when you separate from service and roll your money out of the plan. The accumulated after-tax contributions of $265,000 can be rolled into a ROTH IRA, which allows for tax free accumulation of future earnings and qualified withdrawals. Another attractive attribute of a ROTH is the fact that required minimum distributions do not apply to ROTH accounts for the original account owner, so if you don’t need this money during your lifetime it can remain in the account untouched until you pass it on to your heirs.
So what’s the catch? For one, taxes. Any after-tax contributions are taxable to the plan participant in the year deposited (including payroll taxes). Making sure you have adequate withholding or other liquid assets to cover the additional tax liability is key to using after-tax contributions viable as a long-term planning strategy. It may also not be appropriate to make after-tax savings in your retirement plan depending upon your household asset mix, plan provisions, tax situation and goals. A second drawback is that this money becomes subject to the same provisions as pretax money regarding withdrawals, loans and rollovers, with a twist of course. Distributions from the account are made pro-rata between pretax and after-tax balances, meaning that you likely won’t be able to fully access your pretax funds without penalty until you separate from service or retire. Before doubling down on retirement plan contributions, make sure that this savings method is consistent with your overall financial plan and investment strategy.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs.