After-tax 401(k) contributions are not the same as Roth
While after-tax and Roth 401(k) contributions appear similar on the surface, they’re actually quite different. So I thought I’d expand on the topic.
In addition to traditional tax-deferred contributions, many 401(k) plans also allow you the option to make Roth contributions. Like Roth IRAs vs traditional IRAs, Roth 401(k) accounts are treated the opposite of tax-deferred 401(k) accounts. The money you contribute to a Roth 401(k) is after-tax, but all money eventually comes out tax-free (assuming you meet certain conditions).
The IRS sets limits on how much you can contribute to your 401(k) plan on a tax-deferred and/or Roth basis. For 2020, that amount is $19,500 if you’re under 50 or $25,000 if you’re 50 or older. It’s important to note that these contribution limits are shared between tax-deferred AND Roth contributions. For example, you can’t contribute $19,500 to your tax-deferred 401(k) and then contribute another $19,500 to your Roth 401(k).
In addition to tax-deferred and Roth contributions, many 401(k) plans also allow for a third type of contributions…“after-tax” contributions. After-tax contributions are made with after-tax money like Roth contributions, but they go into the tax-deferred account like tax-deferred contributions.
After-tax contributions do NOT count toward your $19,500 (or $25,000) annual contribution limit; they fall under a different limit. For 2020, when including after-tax contributions and money contributed by your employer, the IRS allows total 401(k) contributions of $57,000 if you’re under 50 or $63,500 if you’re 50 or older.
It’s important to note that the amount of the after-tax contribution itself won’t be taxable when withdrawn; only the gains attributable to that contribution will be taxable. For example, assume you contribute $55 to your 401(k) through a tax-deferred contribution and another $35 through an after-tax contribution. And then assume you have $10 of gains on the $90 contributed. In this case, 35% of the $100 in the account has already been taxed. Therefore, when you take a withdrawal, only 65% of it will be taxable.
You should generally only make after-tax contributions if you’ve already used up your $19,500 (or $25,000) limit on tax-deferred and/or Roth contributions AND you still want to save more in your plan.
However, if you do fill up your $19,500 (or $25,000) limit and want to save extra, first consider contributing to a Roth IRA. If you max out your Roth IRA contribution and still want to save even more, then consider an after-tax 401(k) contribution.
After-tax 401(k) contributions can also allow you to do what’s called a “mega backdoor Roth contribution.” I’ll save that topic for another day.
Disclaimer:
None of the information provided herein is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Tenon Financial LLC does not promise or guarantee any income or particular result from your use of the information contained herein. Under no circumstances will Tenon Financial LLC be liable for any loss or damage caused by your reliance on the information contained herein. It is your responsibility to evaluate any information, opinion, or other content contained.