Tax Efficient Planning with After-Tax 401k Contributions

A few posts ago we discussed there may be options to save more than the regularly referred to contribution limit in a 401k, this is referred to as an after-tax contribution. Here we will discuss the pros and cons of making an after-tax contribution.

How do After-Tax Contributions Work from a Tax Perspective?

With an after-tax contribution, it goes into your 401k as you would expect, after paying tax on it. With a traditional 401k contribution or pre-tax contribution your income is reduced at the time is contributed so you don’t pay tax on the amount contributed. With an after-tax contribution it is just the opposite. Check out this example:

• Pre-tax: You are an executive making $200k and contribute $10k pre-tax, your income would be taxed as if you made $190k. Since the $10k was not taxed today, upon withdrawal the contribution +/- any gains would be taxed. So, say the $10k grows to $30k upon withdrawal in retirement, ordinary income taxes would occur on the full $30k.

• After-tax: You are an executive making $200k and contribute $10k after-tax, your income would be taxed as if you made $200k. This too has the same opportunity to grow and lets say it grows to the same $30k as before. Upon withdrawal in retirement the original $10k would not be taxed as it was already taxed when contributed. The remaining $20k of gains would be taxed as ordinary income.

Enter a Rollover IRA and Roth IRA

Say we have the same after-tax situation, but then the executive elects to rollover their 401k. After-tax contributions are eligible to be rolled over to Roth IRAs and the gains on an after-tax contribution are eligible to be rolled over to a Rollover IRA (among other similar account types). Here is the big difference, Roth IRAs grow Tax-free! What does this mean? Lets re-run the example:

After-tax: You are an executive making $200k and contribute $10k after-tax and then roll these funds into a Roth IRA. This too has the same opportunity to grow and let's say it grows to the same $30k as before. Upon withdrawal in retirement the original $10k would not be taxed as it was already taxed when contributed. The remaining $20k of gains accrued in a Roth IRA and therefore would also not be taxed!

Implications for After-Tax 401k Investors

There are more details and variables to determine if this strategy right for you, such as the plan, expenses, goals and the remainder of your financial situation that are beyond the scope of this post.

If you would like to have one of our Financial Advisor’s review your situation to see if the above strategy may work for you, please contact us here.

Disclosures:

Wooster Corthell and the author are not tax professionals and do not give tax advice. You should consult your tax professional regarding your individual circumstances.

This commentary reflects the personal opinions, viewpoints, and analyses of Wooster Corthell Wealth Management, Inc. “WCWMI” employees. The information presented should not be viewed as a comprehensive analysis of the topics discussed but instead is general in nature.

The views reflected in the commentary are subject to change at any time without notice. WCWMI makes no representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented.

This commentary may contain information that might assist you in the development of subsequent discussions with the appropriate professionals and should not be construed as tax planning, estate planning or insurance advice. Neither WCWMI nor its employees are accountants, attorneys, or insurance agents. Therefore, please consult your tax professional, attorney, and/or insurance agent regarding your specific situation.

Wooster Corthell Wealth Management, Inc. has been an Investment Adviser registered with the Securities and Exchange Commission since 2001. Registration does not imply any level of skill or training. Additional information about us is available on the SEC's website at www.adviserinfo.sec.gov.