The 401(k) Option That You've Probably Never Heard Of

Erik Carter, Contributor

 

Last week, I wrote about some ways that high income earners can protect themselves from rising taxes.  However, I left out one method that many people don’t even know exists and that is to make after-tax contributions to a retirement plan like a 401(k). No, I’m not referring to the new Roth 401(k) plans. I mean being able to put additional money into your 401(k) above the $17k per year cap (or $22k if you’ll be age 50 or above this year) after-tax. (The IRS limit for the total of all annual contributions is the lesser of $50k or 100% of your compensation.) If you check with your retirement plan provider, you may be surprised to discover that this option is available. Here are some factors to help you decide if it’s an option worth considering.

Are you maxing out your pre-tax and/or Roth contributions? 
You’ll probably want to make sure that you’re maxing out your pre-tax or Roth contributions first. Roth contributions are also after-tax but the earnings are tax-free after age 59 1/2 as long as the account has been open for at least 5 years. In contrast, earnings on after-tax contributions are still taxable when you withdraw them. That makes Roth contributions clearly superior.

As for pre-tax contributions, the only way that after-tax contributions can come out ahead is for your tax rate to be significantly higher when you make withdrawals. In that scenario, you might be better off paying the tax on the contributions now rather than later. But you have to ask yourself how likely that is, considering that people typically have less income in retirement and a lot of your 401(k) withdrawals may be taxed at lower brackets. In addition, that benefit is at least partially offset by the fact that you can afford to save more pre-tax since those contributions have a smaller effect on your paycheck than after-tax contributions, which reduce your paycheck dollar-for-dollar.

Would you end up paying more taxes and penalties in the after-tax account?
Even if you’re maxing out your pre-tax or Roth contributions, you still might be better off putting money in a taxable account for a couple of reasons. First, under current tax law, you’ll end up paying a lower tax rate on long term capital gains (except maybe on collectibles) in a taxable account since earnings from the after-tax account are taxed at higher ordinary income tax rates when they’re withdrawn. This is less of an issue if you invest the after-tax account in bonds since the interest is taxed at ordinary income rates anyway. The same would also be true of stock dividends if the lower tax on qualified dividends expires next year as scheduled.
Second, a taxable account provides more flexibility as you can withdraw your money anytime and for any reason without worrying about early-withdrawal penalties. On the other hand, even if your retirement plan allows you to withdraw from the after-tax account, a pro rata percentage of your withdrawals would be considered earnings and possibly subject to a 10% penalty if you’re under age 59 1/2. This is an important factor if you might need the money before then.

Would you like to contribute more to a Roth?
There is one really good tax reason to contribute to an after-tax account though. That’s the ability to contribute additional dollars into your retirement plan that can later be rolled into a Roth account. (Don’t forget that you’ll still need to pay taxes on the after-tax earnings when you do so.) If your employer offers you a Roth option, you might even be able to convert it to a Roth while you’re still working there. Otherwise, you can roll the after-tax money into a Roth IRA after you leave your job. This can be a particularly good move if you’re still early in your career since you’re likely to change jobs at some point and will still have plenty of years to benefit from tax-free growth.

Does your 401(k) offer superior investment options?
Taxes aren’t everything. You might want to contribute more to your 401(k) rather than a taxable account because it offers a unique investment opportunity that you want to take advantage of or mutual funds for a lower cost than you can purchase outside. These are valid arguments for an after-tax account too.
After-tax contributions are obscure for a reason. Most people don’t really need them and many retirement plans don’t even offer them. But if you’re maxing out your pre-tax and/or Roth contributions, have additional dollars to invest, don’t need the funds before age 59 1/2, and would like to invest the money in bonds, choose investments unique to your 401(k), or eventually roll it into a Roth account, you might want to consider making after-tax contributions. Just don’t be surprised when no one else knows what you’re talking about.

Erik Carter, JD, CFP® is a resident financial planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.