The Hidden Benefits of After-Tax Contributions
November 20, 2014No, I’m not talking about Roth contributions. If your employer’s retirement plan offers this option, you may be able to contribute more than the annual limit of $17,500 (or $23,000 if you’re 50 or older) to your plan in the form of “after-tax” contributions. As the name implies, the contributions are taxed before you put them into the plan. And unlike Roth contributions (which are also “after-tax”), the earnings are taxed when you withdraw them.
At first glance, this actually doesn’t look like a good deal. That’s because if you invested that money in a regular investment account, any capital gains after one year would be taxed at a lower tax rate. However, in the “after-tax” account, those gains would be taxed at a higher ordinary income tax rate no matter how long you’ve held the investments. Not only that, but if you’re under age 59 ½, you may have to pay a 10% penalty on the earnings as well.
So why would anyone want to contribute after-tax? The obvious reason would be to hold investments like taxable bonds that are subject to ordinary income taxes anyway. There are also a couple of hidden benefits too.
To use a stable value fund for short-term goals
Many 401(k) plans have stable value funds. Like cash, they don’t fluctuate in value (hence the “stable” value) but they tend to pay a lot more in interest. Some pay as much as 3%, which is more than 10 year treasury bonds are currently yielding.
However, stable value funds are only available in employer-sponsored retirement plans so you generally can’t use them for short-term goals…unless they’re in an after-tax account. That’s because the after-tax money is held separately from your pre-tax and Roth money and it can typically be withdrawn at any time, even if you’re still employed by the company. The one catch is that if you’re under age 59 ½, you have to pay a 10% penalty on the earnings you withdraw.
But so what? If you’re earning 3% and pay a 10% penalty, that still leaves you with a 2.7% return on your withdrawals, which is a lot better than you’re probably getting in the bank. Of course, the money you don’t withdraw is still earning the full 3% too. (Even if your stable value fund is paying a lower 2% rate, that still leaves you with a respectable 1.8% after the penalty.)
That means you can use after-tax money invested in a stable value fund to earn more on savings for emergencies or for other short-term goals like saving for a home or college expenses in a few years. Whatever you don’t use can continue growing tax-deferred for retirement. If you know you don’t need it for short-term goals, there’s an even better option for the long term…
To contribute more to a Roth account
Another big benefit of having after-tax contributions is that you can roll that money into a Roth IRA so it can grow to be tax-free after 5 years and age 59 1/2. (If your plan allows it, you may also be able to convert that after-tax money into a Roth account within your plan.) This allows you to contribute more to a Roth account than the normal limits.
Normally, you have to pay a tax on any earnings when you roll it into a Roth IRA. However, a recent IRS ruling allows you to roll the earnings into a traditional IRA (and hence defer the taxes) and roll the nontaxable contributions into a Roth IRA. Other than losing access to the previously mentioned stable value fund and any other investments unique to your plan, there isn’t much downside here. Tax-free sure beats tax-deferred.
So if you have an after-tax option in your employer’s plan, don’t dismiss it so easily. It can be a good option for short-term savings or for long-term tax-free growth. Now if only we had that option at Financial Finesse…