The 11-year bull market that ended at the beginning of the year seemed to lull a lot of investors into complacency and set the bar high for expected returns. If you look at the last couple of years, the S&P 500 returned over 19% in 2017 and over 28% in 2019. (1) Returns like that make it easy to become overconfident in your savings and investments.
However, the market turmoil brought on by the coronavirus containment efforts has been a wake-up call for many investors. No longer confident and comfortable, they are now looking to bolster their savings rate. If you are one of those investors, you may want to consider making after-tax 401(k) contributions.
What Contributions Can You Make To A 401(k) Plan?
If your employer offers a 401(k) plan, you are probably already making contributions. You can contribute up to $19,500 a year pre-tax in 2020, or $26,000 if you are over the age of 50. Did you know that you can actually contribute more than that to your 401(k) account? That is only the limit for pre-tax contributions or Roth contributions. Beyond that, you may be able to make after-tax contributions as well.
There is more than one limit that applies to 401(k) account contributions. The first we just discussed applies to employee tax-advantaged contributions and is the one that most people are familiar with. However, employers contribute to 401(k) accounts for their employees too. The IRS also limits that. Total combined contributions from both employees and employers cannot exceed $57,000 or $63,500 for those over age 50.
For example, let’s say that you contribute the maximum $19,500 pre-tax and your employer matches it completely. That is $39,000 total going into your account. That is still $18,000 less than the IRS combined limit. You can make an additional $18,000 in after-tax contributions.
How After-Tax 401(k) Contributions Are Taxed
Those contributions, as the name implies, are made with after-tax money. Unlike Roth contributions where all of the growth is tax-free, you will have to pay taxes on any gains. Gains are considered pre-tax money and are taxed as ordinary income when withdrawn from the account.
After-tax contributions can be withdrawn from your 401(k) at any time without taxes or penalties. The gains, though, are subject to taxation and also a 10% penalty if withdrawn before age 59½. What makes it hard is that you cannot only withdraw contributions and leave the gains in the account; both portions come out together, so any withdrawals incur a tax liability if there are gains.
Benefits Of Making After-Tax 401(k) Contributions
One of the major benefits of making any kind of 401(k) contributions, regardless of the tax advantages, is the creditor protections. Money in a 401(k) plan is protected from creditors and bankruptcy. That is unique to some retirement plans and a benefit that you will not have when investing in a taxable brokerage account.
The most common strategy that after-tax 401(k) contributions are used for is doing Roth conversions. Being an after-tax contribution, it can be converted to a Roth without having to pay taxes on the principal, only the earnings. Once converted, then the balance of the account can continue to grow completely tax-free.
If your 401(k) plan offers a Roth option, then you may be able to do an in-plan conversion. This is an easy way to get your money into a Roth account while you are still at the same employer. It does constitute a taxable event and you will have to pay taxes on any earnings that have accumulated thus far.
When you cannot convert to a Roth within your 401(k) plan, then you have to roll your money into an IRA to do so. Some plans allow you to do that while still employed, but in many cases, you will have to wait until you change employers. Even if you have to wait, the benefits of having your money in a Roth IRA, such as having no required minimum distributions, can make it worthwhile.
Are After-Tax 401(k) Contributions Right For You?
After-tax 401(k) contributions can be an excellent way to invest more money for tax-deferred growth. Still, they should be considered in light of your overall financial plan and goals. If you don’t already have a financial plan and a trusted advisor, we can help. Contact us at (626) 529-8347 or email Ricky directly at email@example.com and we can discuss your overall financial life and which strategies will best help you achieve your goals.
About Haydel, Biel & Associates
Haydel, Biel & Associates is an independent financial advisory firm serving individuals and families near Pasadena, California. The firm was founded in 2004 by Chris Haydel and Ricky Biel with a desire to provide unbiased, client-centered, community-based financial advice. Together, they have built a practice that has grown into a family of caring, smart professionals committed to blending proven investment methodologies with creative financial technologies that make it easier than ever to accomplish your goals. They strive to keep things simple and fun to give their clients peace of mind and alleviate financial stress. HBA Wealth takes care of their clients’ needs first and foremost and goes the extra mile to make their clients’ finances grow. To meet and see how the HBA Wealth team may be able to help, contact them today at (626) 529-8347 or email Ricky directly at firstname.lastname@example.org.
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