401k Planning: Why You Might Want to Consider After-Tax Contributions

August 19, 2016 · Written By Robert Vogel, CFP®

Does your 401(k) plan allow you to make after-tax contributions, once you’ve maxed out your elective deferrals?  This often overlooked feature is available in about 42 percent of 401k plans, but only about 6 percent of participants take advantage of the option.

Many people may ask, “Why would I want to make after-tax contributions to my 401k plan?”  There are actually several potential reasons, and a somewhat recent ruling by the IRS adds one more… Let’s review them in turn:

1.  Simplification

If most or all of your retirement savings are accumulating through employer-sponsored plans, after-tax contributions allow you to increase savings beyond the statutory limits, but still take advantage of the same investment offerings.  This may be a smart play for individuals who don’t have significant assets outside their defined contribution plans. For them, finding a wealth management expert to help invest any excess cash may prove difficult, or be prohibitively expensive.

2.  Early Retirement

Retirement savings are generally subject to withdrawal penalties before age 59 ½.  For participants of 401k plans who retire from service, the threshold is moved forward to age 55.  If you retire earlier than that, the options to access your retirement funds are severely limited.

Meanwhile, if you are between the ages of 55 and 59 ½, you may feel the options in your plan do not sufficiently meet your needs. You might prefer to roll your assets over to an IRA.  After-tax contributions to a 401k plan can be lifted out and moved to a taxable account with no tax liability (growth on the contributions remains in the plan).  This strategy can provide a source of funding until you reach age 59 ½, while helping you avoid IRS penalties.

3.  Tax Management

Rolling after-tax contributions to a taxable account can also be a smart way to manage taxes early in retirement. Essentially, you can complement your retirement funds with a bucket of after-tax money, which will be fully taxable upon withdrawal.  If you have higher taxes early in retirement (from a spouse who is still working, for example), you can draw down on the after-tax funds with little to no additional tax liability.

4. Roth IRA Funding

A Roth IRA is a powerful savings vehicle. Contributions are made with after-tax dollars, and they grow tax-free as long as certain conditions are met.  For many families, these accounts are an important part of retirement planning and useful for tax management in retirement.

In September 2014, the IRS added another great opportunity for those who have made after-tax contributions into their 401k.  Notice 2014-54 allows those with both pre-tax and after-tax money in their 401k plan to move the after-tax money directly into a tax-free Roth IRA (with the pre-tax money going directly to a Traditional IRA).  This could allow a participant to superfund a Roth IRA during pre-retirement, when their AGI will not allow direct contributions.

Example:
$18,000 Pre-tax contribution
$6,000 catch-up contribution (age 50+)
$10,000 employer match
$20,000 after-tax contribution (later to be rolled to Roth IRA)

Following the above example for five years, before retirement, would pre-fund a Roth IRA with $100,000.
This is three times more than if you could contribute directly!

Being able to take advantage of these kinds of opportunities is one of the many benefits of working with a JFS financial advisor.  Does your 401k plan offer the ability to make after-tax contributions?  Is this something you should consider?  JFS Wealth Advisors are always happy to review your options, and how they fit into your overall financial plan.