3 Reasons To Make After-Tax Contributions To Your Retirement Plan
April 25, 2016Updated for current tax figures
Are you lucky enough to have the option to save after-tax money in your employer’s retirement plan? Most employees probably haven’t given it a thought, and not many utilize the option to save more than the current $18,500 pre-tax annual employee contribution limit (plus another $6,000 if you are 50 and older).
In fact, many people are not even aware that they may be able to save additional money in their employer-sponsored retirement plan, in some cases up to the annual total defined contribution limit (from both employee and employer) of $55,000 (plus $6,000 catch up if 50 and older) or 100% of your compensation, whichever is less. Sure, the likelihood of saving that much for many people might be small.
However, if you are already contributing the maximum in pre-tax and Roth contributions, here are some reasons to save more after-tax:
Automatic savings
Saving for an early retirement or financial independence? Let’s face it. It’s unlikely you’d save that much or invest on such a consistent schedule if you had to write a check every two weeks to a mutual fund company.
That’s one reason your employer can be your best financial services provider. Saving after-tax money in your retirement plan can be as easy as clicking a button or signing a form to choose what percentage of your salary you want to save. Every paycheck, you’ll defer money into after-tax savings and invest them in plan funds, just like your regular contributions. Little by little, you’ll save and grow that extra money without having to think about it.
Ability to withdraw contributions
You should generally be able to withdraw after-tax voluntary contributions, subject to the plan guidelines on withdrawals, even before you’re 59 1/2 and without meeting a specific need like you often do for a hardship withdrawal. That means if you have an emergency, you will be able to access those funds.
However, you may not be able to withdraw associated earnings growth, and if you are, those earnings – but not your original contributions – would be subject to taxes and a 10% penalty if withdrawn prior to age 59 1/2.
Tax-free rollover to a Roth IRA
You’ll reap the biggest rewards from your after-tax contributions when you leave your company or retire. Assuming you’ve been saving for a while, your after-tax balance will contain two components: your original after tax contributions and the tax-deferred earnings growth on those contributions. The IRS allows you to separate those two components out during the rollover process, so you can do a direct rollover into multiple destinations: rolling the tax-deferred earnings growth into a traditional IRA and rolling your after-tax contributions into a Roth IRA.
That’s right. You read that correctly. Your after-tax voluntary contributions can be rolled into a Roth IRA, where any future earnings growth will then be tax-free (assuming you leave the money in the Roth for at least five years and until after age 59 ½ ). You may even be able to convert your after-tax contributions immediately to Roth and have all future growth tax-free (but then you give up the ability to withdraw it early).
Here’s an example: Jane is already contributing the maximum $18,500/year to her pre-tax 401(k) plan at XYZ Company. She wants to save extra for retirement, so she saves an additional $10,000 annually in after-tax voluntary contributions in the plan.
After 10 years, Jane has about $144,000 from her after-tax contributions ($100,000 in contributions and $44,000 in growth). She also has about $260,000 in pre-tax savings and growth from contributing the maximum. When she leaves XYZ to take a new job, she can roll her plan balances into multiple destinations: $100,000 into a Roth IRA and $304,000 into a traditional IRA or her new employer’s 401(k) plan.
Fast forward another 15 years to when Jane retires. Without adding any more money to her Roth IRA and receiving a 7% return, her account is now worth about $285,000. That’s an additional $185,000 of tax-free growth, all because she originally saved after-tax money in her 401(k) plan.