An after-tax contribution is exactly what it sounds like: Money put into a retirement plan after the contributor has paid income taxes on that money.
Most people make contributions that are pre-tax, that is, they contribute money from a paycheck or business income that is not taxed during the year the money is put away.
The result is that income taxes are lower that year, a move which often increases the amount one can afford to save.
It’s not that pre-tax money is never taxed. When the saver decides to take money out of a 401(k) or IRA later, in retirement, the withdrawals are taxed.
The tax rate then is that person’s ordinary income tax rate when the money is taken out.
The advantage here is that the investor saves money on taxes once, at contribution, and presumably again, later, because income is lower in retirement for most people.
Because income is lower the tax rate applied to the withdrawal is lower, too. It’s a win-win for most folks.
So why make an after-tax contribution?
Because while you pay taxes on that income this year, the growth is tax-free, usually for decades.
In a taxable investment account one must pay taxes on investment you sell in the form of either short-term or long-term capital-gains taxes.
Likewise, a taxable account that generates dividends also generates income taxes since dividends are income.
If the money is contributed to a tax-advantaged retirement account, such as in a 401(k) or IRA, capital-gains taxes are zero and dividend income is not taxed, either.
What’s more, the saver can withdraw contributions if necessary — but not any gains or dividends — without have to pay taxes on those withdrawals.
Most people believe that their elective deferral to a 401(k) is the same as their maximum possible contribution. That’s not true.
An elective deferral means money taken out of a paycheck by an employer and placed in a 401(k).
That number maxes out currently at $18,500 a year. If you are 50 or older, you can add on another $6,000 to reach $24,500.
Any money put in by your employer as a match doesn’t count against the elective deferral limit. Likewise any after-tax contributions you make to your own account don’t count against the limit.
The real ceiling for total contributions (elective and after-tax) is $55,000 a year, or $61,000 if you are 50 or older.
While it’s true that not many people are in a position to save more than $18,000 a year, some are and might want to put away more money in order to better manage an impending retirement.
Whether making an after-tax contribution to a 401(k) or an IRA is in your financial interest in retirement is a matter of your actual tax burden later in life.
Always consult a tax professional when planning investments that might alter your tax bill in future years.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.