Employer retirement benefits have evolved. We used to think about the 401(k) or 403(b) plan as a place where we put pre-tax money to grow tax-deferred and get some additional compensation through the ‘employer match.’ Not any more. More and more plans now offer other benefits that are at least as important to help you save for retirement: the ability to make Roth and after-tax contributions. But what are these options and when does it make sense to use them?
Roth contributions
In the typical 401(k) or 403(b) plan, you make pre-tax contributions: In the year you make the contribution, that amount does not count toward your taxable income. Your savings will grow tax-exempt until you withdraw them, at which time they will be taxed at your marginal tax rate at the time of withdrawal, whatever that may be. Many plans, however, let you make Roth contributions. In a Roth, the amount contributed counts towards your taxable income this year, but you will never owe taxes again on these savings. Plans that offer Roth contributions let you split your savings between Roth and pre-tax as you choose. The annual limits ($19,500 plus $6,500 of you are 50 or older) apply to the combined amount across account types.
After-Tax contributions
More and more plans are offering the ability to make after-tax contributions, not to be confused with the Roth contributions above. A plan may offer both Roth and after-tax contributions, or just one of the two options. Like the name implies, after-tax contributions count as taxable income the year they are made. They grow tax-deferred (“TD”), and the earnings portion of your savings will be taxed as ordinary income when withdrawn. If you put in $10,000 after-tax, which later grows to $12,000, the $2,000 in earnings is taxable income if withdrawn. The initial $10,000 contribution is considered a return of principal and not taxed.
The limits on after-tax contributions are relatively generous. For 2020, they are based on a maximum of $57,000 across elective contributions (the $19,500 annual), employer contributions, and after-tax contributions. Say you make $180,000 and are less than 50 years old. You max your annual contributions of $19,500, and your employer contributes $7,200 (4% of your income). You can contribute an additional $30,300 (= 57,000 – 19,500 – 7,200) after tax. You can contribute after tax even if you do not max your pre-tax contributions, in which case you can put even more than the $30,300 above.
Start with a goal
You may have heard that a good reason to save in a 401(k) plan is to get a ‘company match,’ or get some tax-advantaged growth. But the real reason we are doing it is to achieve a comfortable retirement. So start by understanding what your future income trajectory may look like, and what your retirement needs may be. Consider the trajectory of your potential future tax brackets. Then think of your plan options like this: Which choice will help me get the most out of a dollar saved for my retirement goal?
Two basic economic principles can help you answer the question: (1) there is a tax-drag to growth in a taxable account, but not in a tax-deferred or tax-free account, and (2) smoothing your marginal tax rate over time can help you lower the taxable portion. Both Roth and after-tax contributions can help you with (1) and (2) if you understand your retirement needs and your likely taxable income trajectory.
Why you may want to consider a Roth account
Think of Roth and traditional tax-deferred (TD) account options as tools to help you reduce the expected tax of your savings (principle 2).
- If you are likely to be in a lower income bracket now than in the future, Roth contributions can help you smooth your marginal tax rate and keep it low over time. This can happen particularly if you are young and on a steep income trajectory, or as the TCJA rates sunset in 2025, or if you have a year with particularly low income (could be 2020 for many).
- Don’t forget the impact of reducing taxes today on future taxes. For example, if you have most of your savings in a TD account, the required minimum distributions (RMDs) after age 72 may be large enough to put you in a higher tax bracket. Similarly, withdrawal from TD accounts can increase the taxability of your social security, unlike Roth distributions that are not counted as income.
- Keep in mind that Roth contributions also allow you to save relatively more money in tax-exempt growing assets. When you save $19,500 in a Roth account, you are effectively saving more after-tax dollars than if you save the same amount in a pre-tax 401(k), because you know that a fraction (equal to your future marginal tax rate) of the $19,500 pre-tax will be taxed. If you are currently in a low or steady income bracket, you may consider Roth as an option.
If Roth contributions make sense for you, but your income is too high to make Roth IRA contributions, the Roth 401(k) is a great alternative and comes with higher limits than an IRA.
When not to use the Roth? You may not want to consider Roth contributions if you are in a high income bracket, or think your tax rate in the future may be lower than this year’s. In this case you may want to use a TD account to help you lower today’s tax rate.
Why you may want to consider after-tax contributions
After-tax contributions are a great source of increased access to tax-advantaged savings beyond the annual limits, both in tax-deferred and tax-exempt form. After-tax contributions have similar advantages as the Roth contributions above. Typically, if your income is high enough, you will need to save more for retirement than the annual limit allows. Thus, it may be optimal to first fill out the tax-deferred bucket to lower your income tax today, and use the after-tax for additional savings.
- A dollar in an after-tax account can be worth more for your retirement than a dollar in a taxable account because of principle 1. You can save an extra dollar in the after-tax 401(k) account, where earnings are taxed when you withdraw, or a brokerage taxable account, where growth is taxed annually. With a long retirement horizon, the benefits of tax-deferred growth can mean a greater (net of tax) return from the after-tax 401(k) account than from the taxable account.
- And there is more. You can convert your after-tax contributions to Roth contributions. This can be done within the plan if allowed, or outside of the plan. The contributions can be converted to Roth without additional tax liability, while the earnings portion will be subject to income tax. Once converted, your entire Roth savings will be tax-exempt.
The second bullet point implies that after-tax contributions give you (a relatively large) access to Roth savings. This is why after-tax contributions with Roth conversions are referred to as a mega back-door Roth strategy.
Strategies with after-tax contributions
The simplest strategy is to convert the after-tax contribution to a Roth within the plan if the plan allows it. This way, any future earnings will grow tax-exempt. Some plans allow you to set-up automatic Roth conversions. If not, some plans allow you to make in-service withdrawals. This means you can withdraw the after-tax savings and roll them over to an IRA while you are still employed. When you roll over, you can choose to roll over to a Roth account, by paying income tax on the earnings portion of the withdrawal. In this case, it’s important to understand IRS rules and the rules of the plan.
Finally, if neither is allowed, you can roll over the after-tax money to a Roth IRA when you retire or separate from the company.
By combining after-tax contributions with Roth conversions, you now have access to a Roth account with relatively generous contribution limits. This makes the 401(k) with after-tax contribution a good vehicle for retirement planning. The pre-tax portion helps you lower the tax rate today, while the after-tax portion helps you lower the tax rate in the future. You can balance the two to help you lower your overall tax rate.
The key to this process is to start with your goals and project your future income. Given the typically large benefits, it’s worth spending some time planning or seeking the help of a trusted advisor.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
