What you need to know about after-tax 401(k) contributions
Do you want to save more for retirement but you've already maxed out your 401(k) contributions for the year? You might be missing an opportunity for extra savings in your company's 401(k).
If your plan allows for after-tax contributions, you can save beyond the pre-tax annual contributions limits—and still have your contributions grow tax-free. While it's not the right strategy for everyone, it helps to understand the basics so you can make an informed decision on your savings.
After-tax 401(k) contributions: The basics
The IRS has two defined limits for annual contributions to a 401(k) plan each year: the pre-tax contributions limit and the total contribution limit. In 2022, those IRS limits1 are:
Pre-tax contribution limit: $20,500 ($27,000 for those age 50 and older)
Total contribution limit: $61,000 ($67,500 for those age 50 and older)
The total contribution limit includes employee contributions as well as employer matching contributions and profit-sharing contributions (which give employees a share of the company's profits based on its quarterly or annual earnings). For example, say you're under age 50 and make the maximum $20,500 pre-tax contribution to your 401(k) in 2021. If your employer's matching and/or profit-sharing program contribute another $14,500 and your 401(k) plan allows after-tax contributions, you could potentially save an extra $26,000 ($61,000 - $20,500 - $14,500) as after-tax contributions.
It's worth noting that not all 401(k) plans allow for after-tax contributions. A quick conversation with your HR department can get you the details on your company's plan.
Potential benefits of after-tax 401(k) contributions
The ability to save more for retirement just scratches the surface of the potential benefits of after-tax 401(k) contributions. You could also enjoy:
- Tax-deferred growth. If you make trades within your 401(k) account before retirement, you won't face capital gains taxes. And your dividends can be reinvested without incurring any taxes. The only time you'll pay taxes on your gains is when you begin taking distributions in retirement. (And note, you won't pay taxes on the after-tax principal you contributed.)
- A larger emergency savings cushion. Since you're making contributions after-tax, you can generally make withdrawals from these funds tax-and penalty-free.2 By contrast, tapping into your pre-tax contributions typically means incurring both early withdrawal penalties and taxes.3 (If you need to do either, speak with your tax advisor for details.)
- Possibility to roll over funds into a Roth IRA. You may be eligible to roll over your after-tax contributions into a Roth IRA using a strategy called a mega backdoor Roth IRA. Roth IRAs and after-tax 401(k) contributions are alike in that you fund them both with aftertax money. However, the earnings on an after-tax 401(k) contribution are taxable, while the earnings in a Roth aren't. A mega backdoor Roth allows you to convert your after-tax 40(k) contributions to a Roth account and lower your taxable income in retirement. Although you must pay taxes on the earnings when you roll the funds over, if you time it right you can minimize potential gains. A mega backdoor Roth is a highly nuanced strategy4 best discussed with your tax advisor. But if you qualify, it could help you access Roth IRA benefits even if your income is too high to contribute to one. This strategy might have new limits placed on it by Congress.5 Your tax professional can help keep you up to date.
With after-tax 401(k) contributions, you could be eligible to save up to an additional $40,500 for retirement.
As with any investment or savings strategy, there can be drawbacks. For after-tax 401(k) contributions, you should consider:
- Limited investment options. Since most 401(k) plans have limited investment options, you may prefer the flexibility of a taxable investment account.
- Rollovers aren't easy. If you want to rollover your after-tax contributions into a Roth IRA, you'll need a plan that offers in-plan conversions or in-service withdrawals6 (and yes, they're different). Otherwise, you'll have to wait until you leave the company to do a rollover, which might not be in your plans.
- No tax savings. While you can save more for retirement, you won't get any tax break come tax time.
Alternatives to Making After-Tax 401(k) Contributions
If you're looking for more ways to save for retirement, you're not limited to making after-tax contributions to your 401(k). There are other ways that you save more—and potentially, with greater flexibility.
These have the potential to lower your taxable income in the year you make the contribution.
- IRAs. If you haven't already opened an IRA and maxed-out the annual contribution, you could save an additional $6,000 per year ($7,000 if you're age 50 or older)7 in a Traditional IRA and still reap the same pre-tax benefits you enjoy with your pre-tax 401(k) contributions. Just keep in mind that your tax benefits may be limited or eliminated entirely if you also have a 401(k) plan at work.8
These alternatives don't offer tax benefits now, but they're another option for boosting your retirement savings.
- Roth IRA. If you qualify for a Roth IRA, you might want to consider maxing out your Roth contributions before making after-tax contributions to a 401(k). Both your original contributions and the earnings on those contributions tax-free withdrawals at retirement. Taxable investment accounts.
- Taxable investment accounts let you choose your own investments. They also offer easier access to funds without the distribution paperwork required with a 401(k). The accounts are available at a wide variety of online brokerages or through your financial advisor.
The bottom line on after-tax 401(k) contributions
After-tax 401(k) contributions are an often-overlooked strategy to boost your retirement savings. To help decide if this strategy is right for you, assess your plan, explore your savings options outside of your 401(k), and speak to your tax and financial advisors.
Important disclosure information
This content is general in nature and does not constitute legal, tax, accounting, financial or investment advice. You are encouraged to consult with competent legal, tax, accounting, financial or investment professionals based on your specific circumstances. We do not make any warranties as to accuracy or completeness of this information, do not endorse any third-party companies, products, or services described here, and take no liability for your use of this information.
- IRS.gov, "COLA Increases for Dollar Limitations on Benefits and Contributions," accessed December 15, 2021. Back
- Fidelity, "What to do with after-tax 401(k) contributions," published January 29, 2021, accessed January 3, 2022. Back
- IRS.gov, "Hardships, Early Withdrawals and Loans," accessed January 3, 2022.3. Michelle P. Scott, "Legislative Threat to Mega Backdoor Roth Conversions," Investopedia, published December 14, 2021, accessed December 15, 2021. Back
- E. Napoletano, "Is The Mega Backdoor Roth Too Good To Be True? " Forbes Advisor, published April 13, 2021, accessed December 15, 2021. Back
- C. Benz, "Is the Backdoor Roth Still Legit?" Morningstar, published January 21, 2022, accessed January 28, 2022. Back
- C. Benz, "2 Ways to Upgrade Your 401(k) Without Leaving Your Job," published April 30, 2018, accessed January 28, 2022. Back
- IRS.gov, "Retirement Topics - IRA Contribution Limits," accessed January 3, 2022. Back
- IRS.gov, "Are You Covered by an Employer's Retirement Plan?" Updated July 1, 2021, accessed January 27, 2022. Back
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