The Case for Making After-Tax 401(k) Contributions

Reason #1: You’ve maxed out your pre-tax contribution levels.

If you are a practitioner saving more than 20% of your income, you may be on pace to maximize your pre-tax 401(k) contributions for the year. However, your retirement planning is far from over. After-tax contributions present an enticing opportunity to supercharge your nest egg's growth. Once your pre-tax limit is reached, you can contribute up to an additional $43,500 per year to a 401(k) (or $43,000 if under 50), which grows tax-free. This lets your money work harder for you than a standard investment account and offers more tax benefits than a Roth IRA. While not for everyone, after-tax 401(k)s are a powerful tool for those seeking to reach the next level of financial freedom. If that sounds like you, it may be time to talk to your plan administrator to determine if you can make after-tax contributions.

One of our clients exemplifies the magnitude of this type of planning case; let’s call her Sally. The story of Sally's retirement planning was filled with strategic maneuvering to maximize her savings. While still employed, she contributed a portion of her salary to an after-tax 401(k) account, which would provide tax-free income in her later years. However, upon leaving her job, Sally had a clever plan to gain even greater benefits. She rolled over her after-tax contributions into a Roth IRA, allowing the money to grow tax-free while also rolling the earnings from those contributions into a traditional IRA. Over time, as her income decreased in retirement, she converted the traditional IRA to a Roth IRA in increments. This brilliant "divide and conquer" approach allowed Sally to reap the rewards of tax-free income without being pushed into a higher tax bracket with a single large conversion. With some creativity and foresight, Sally had secured a comfortable financial future for her retirement.

💡 PLAN LIKE A PRACTITIONER

Some individuals may choose to convert those extra contributions into a Roth account later. Having both Roth and pre-tax assets can be helpful in retirement because it gives you more flexibility in generating income tax-efficiently in the near and long term. It is a concept often referred to as “tax diversification.”

QUESTION: Why contribute to an after-tax 401(k) and not a Roth 401(k) if both are available?

ANSWER: 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 the income-tax-free treatment of earnings.

Reason #2: Your income fluctuates.

If you experience fluctuating incomes, building a savings buffer in an after-tax account could be a smart move. This is especially applicable for practice owners who may save a substantial amount for retirement in one year but very little in another. By utilizing the after-tax account, you can increase savings during the high-income years and ensure sufficient retirement savings even during the low-income phases.

THE BOTTOM LINE

After-tax 401(k) contributions may not be available to every practitioner. But if you are on pace to max 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.

🔷If you need help determining what contribution levels are right for you, please schedule the first step in our planning process.

This content was developed from sources believed to provide accurate information and provided by My NP Advisor. It may not be used to avoid any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.