401k After-tax Possibilities

Have you heard of an after-tax 401k contribution?  If not, you may be interested to learn more about it as it provides an avenue to save more in a Roth-like environment.

Here is how it works - 401k plan contributions are a combination of employee and employer contributions.  There is an annual maximum amount that the employee can contribute pre-tax, meaning contributions made reduce the employee’s taxable income. The employer’s allowable annual contribution is much larger, and the IRS limits the combined annual plan contribution regardless of who makes it.

The following is a simple illustration of what the deferral opportunity looks like for a 45-year-old employee earning $150,000 with a 4% company match in 2020: 

Maximum allowed 401K Contribution:                                                $57,000

Maximum Employee Pre-Tax Salary Deferral:                       $19,500

Employer/Company Match of 4%:                                     $  6,000

Total employee pre-tax and employer                                                  $25,500

Possible for After-Tax Salary Deferral:                                    $31,500

In the example above, if the company’s 401k allows for after-tax contributions, the employee could direct as much as an additional $31,500 to the 401k.

How do after-tax 401(k) contributions help compared to saving in a regular brokerage account?   If you are saving in a brokerage account the earnings are subject to income-tax annually, and capital gains tax the year in which they are recognized i.e. the year when sold.  However, when savings are accumulated in a Roth environment, it’s true that contributions are not tax-deductible, but earnings are not subject to income-tax (if you follow the rules and it’s important to know the rules).

Additionally, in 401k plans that offer Roth 401(k) deferrals there may be an opportunity to convert the after-tax 401(k) contributions to the Roth 401(k) while still in the plan.

Should you take advantage of this opportunity?  The current state of your cash flow, expected large future expenses, level of emergency fund and if you are already maximizing your Health Savings Account all come into play when exploring this opportunity.

There are many things to consider and this is only a brief and general introduction to the topic.  If you want to explore what your company’s Roth 401(k) option could mean for you call us at 855-515-5896.