3 Great Reasons to Consider After-Tax Contributions to a 401(k)
This type of saving method isn't nearly as well-known (or as popular) as regular contributions to a 401(k), but three types of people could benefit from giving it a try.
The 401(k) has evolved over the past few decades, offering flexibility in the way American workers can save for retirement. More companies are offering their workers more than one option on how to use these accounts, and if you are one of the lucky workers who has a choice beyond the usual pretax contribution, you should take a hard look at how you could benefit most.
When given a choice, the majority of American workers opt for pretax contributions, which lower their federal income tax bill in the year they’re made. And although the tax incentive for pretax contributions is a clear benefit no one can discount, it could make more financial sense to take advantage of after-tax contributions if you are among these three types of people:
- Those who are in need of an emergency savings buffer.
- Those who are high-income earners.
- Those whose incomes are volatile.
We will go into detail about each of those three situations, but first it’s important to understand some 401(k) basics.
A little background on how 401(k)s work
A 401(k) is a workplace retirement plan that allows individuals to save for retirement in a tax-favored manner. Employee contributions are withheld from paychecks while employers can match their employees’ contributions up to certain limits. Most workers contribute to their 401(k)s on a pretax basis. (See How Much Can You Contribute to a 401(k) for 2020?) With pretax contributions, employees can reduce their tax bill for that year since deposits into their 401(k) plan are not counted in their taxable income. These contributions grow tax-deferred during an employee’s working years and then withdrawals in retirement are taxed as ordinary income.
With 7 out of 10 large and midsize employers now offering a Roth 401(k) option, many workers also have the option of paying tax up front on their contributions and then taking tax-free withdrawals in retirement. (See How Much Can You Contribute to a Roth 401(k) for 2020?)
A third much less common 401(k) option some employers offer is the after-tax contribution option. Like a Roth 401(k), an after-tax 401(k) contribution is just that, made after taxes are paid. Like a Roth 401(k), earnings grow tax-deferred. However, unlike a Roth 401(k), the earnings on the account are taxed upon withdrawal. The after-tax option predates the Roth 401(k). Of course, if you are saving for retirement and wish to do it on an after-tax basis, the Roth 401(k) is preferable to the after-tax option. Why would you pay taxes if you don’t need to?
At first glance, this thinking may cause workers to dismiss the after-tax option altogether, but there are three reasons why workers could benefit from going the route of after-tax contributions:
Reason #1: You need an emergency savings buffer
We’ve all seen the statistics that show Americans cannot handle even a minor disruption to their incomes. Two-thirds of Americans live paycheck to paycheck, according to Prudential, and 40% of households lack the savings to weather a financial shock. These sobering statistics indicate a strong need for Americans to build emergency savings.
An after-tax 401(k) account can offer a convenient, yet disciplined way to create a designated emergency fund at your workplace. This fund can be used to cover unexpected expenses — without dipping into your pretax savings, which can jeopardize your retirement security and trigger a tax bill and possibly early withdrawal penalties as well. If it turns out you never need that money for an emergency, it becomes an additional source of long-term retirement savings. With the after-tax option you can easily access your after-tax emergency funds should you need them, subject to plan rules or provisions. Generally, your contributions (but not your gains) can be withdrawn at any time tax-free.
Why an after-tax 401(k) and not a Roth 401(k)? While both types of accounts are funded with after-tax money, withdrawals from Roth 401(k)s come with more restrictions — including penalties if you’re not yet 59½ — and you must have had the account for at least five tax years and have reached 59½ to enjoy income tax free treatment of earnings.
How to invest your emergency 401(k) funds: An important thing to remember if you do decide to use the after-tax option in your 401(k) to build emergency savings is to invest the funds conservatively. You would do this because you want to ensure the money earmarked for emergency savings is there if/when you need it, and riskier investments such as stock funds will go down in value from time to time. The rest of your contributions within the 401(k) plan earmarked for retirement could be invested conservatively, moderately or aggressively based on your age and risk tolerance level. Note that if you make a withdrawal from the after-tax portion of your savings earmarked for emergencies while younger than 59½, you will owe a 10% penalty and ordinary income taxes on the earnings (but not contributions) that you withdraw. Therefore, investing conservatively may be optimal. This approach may also cause you to feel more comfortable investing your other funds intended for retirement more aggressively since you will have confidence you can access your emergency fund — and it will be there — if you need it.
Creating an emergency fund within your 401(k) plan keeps all your savings together and leverages the simplicity and ease of payroll deduction. It also provides ready access to your money in a way that traditional 401(k) contributions or even Roth 401(k)s may not.
Reason #2: You’re a high-income earner who has maxed out your pretax contributions
If you are a high-income earner and you’ve already maxed out your 2020 pretax contributions ($19,500 under age 50 or $26,000 if you are 50 or older), after-tax 401(k) contributions might make economic sense for you, too, because they enable you to put more money into your 401(k) plan. For example, those under age 50 can contribute up to $57,000 to a 401(k) in 2020, if their employer allows that. This figure would include pretax, Roth, after-tax and employer contributions. For individuals 50 or older, the limit is $63,500. Contributing after-tax to a 401(k) after you have maxed out your pretax contributions lets you benefit from additional tax deferral on earnings from dividends, capital gains and interest of your investments.
Some people may choose to convert those extra contributions into a Roth account later. Having both Roth and pretax assets can be helpful in retirement because it gives you more flexibility in generating income in a tax-efficient way, both in the near and long term. In fact, one of the hottest financial planning tactics these days is engaging in a year-by-year tax minimization process that looks at which buckets (pretax or Roth) to withdraw from each year based on how each additional dollar will potentially be taxed. (See How to Implement the Bucket System.) To take advantage of this approach, you’ll need both pretax and Roth accounts to withdraw from.
Keep in mind that the Tax Cuts and Jobs Act of 2017 reduced tax rates through 2025, which means it could be a good idea to pay taxes on at least some of your retirement savings now.
Some retirement plans actually allow participants to convert after-tax 401(k) dollars to a Roth 401(k) account through an in-plan conversion. If your plan does not, you can convert to a Roth IRA once you separate from your employer. Alternatively, if you’re not prepared to pay all the taxes that would be due, you can roll your after-tax contributions into a Roth IRA after separation from your employer, while simultaneously rolling your after-tax earnings on those contributions into a regular IRA. You can then convert that IRA to a Roth IRA over time. This allows you to spread the tax hit over a period of years and perhaps avoid being bumped into a higher tax bracket in any one year.
Reason # 3: Your income is volatile
Building a savings buffer in an after-tax account could make sense for individuals who experience volatility in their incomes. For example, an individual in a commission-based sales role might be able to save a lot of money for retirement one year; but if the next year becomes lean, they would only be able to put away a small amount for retirement. Using the after-tax account to increase savings during the years when income is higher can help ensure adequate retirement savings over time despite periods when your income fluctuates.
Bottom line: After-tax 401(k) contributions may not be for everybody. But if you are like the majority of Americans in need of emergency savings or are a high-income earner who has already maxed out your traditional pretax and/or Roth 401(k) contributions and still have money to invest, after-tax 401(k) contributions could make sense for you. Employer plans may not offer a match to contributions made to an after-tax account. Check your employer plan for their rules regarding employer match on contributions and consult with your tax and financial advisers regarding your personal circumstances.
About the Author
Head of Financial Wellness Strategy, Prudential Financial
Vishal Jain is the Head of Financial Wellness Strategy and Development for Prudential Financial. He is responsible for defining Prudential's financial wellness strategy and partnering with a wide range of stakeholders across Prudential in developing and delivering financial wellness capabilities and solutions to the market. For more information, please contact Vishal at email@example.com.