Did you know you can make after-tax contributions to your 401(k) retirement plan? Not many people do.
After-tax contributions have not been a popular retirement vehicle in the past. But with the issuance of IRS Notice 2014-54, after-tax contributions to a 401(k) plan can be used as a vehicle for high-income earners to get large amounts of money into Roth IRA accounts. If you are maxing out your pre-tax contributions and have additional money to contribute, and don’t need the funds prior to age 59½, this option could be for you.
If you are like most high-income earners, you put into your 401(k) the maximum amount allowed by the IRS.
What if I told you that you could put up to 100% of compensation, into your 401(k) plan? That would get your interest, right?
Most people contribute to a 401(k) plan with pre-tax money and reduce their taxable wages. But some 401(k) plans allow participants to make additional after-tax contributions in excess of the pre-tax amounts, up to the annual defined contribution plan limits.
While it’s rarely ever beneficial to make an after-tax contribution instead of a pre-tax contribution, for those who have maxed out on pre-tax contributions, the 401(k) plan may be appealing for making additional contributions above the pre-tax threshold. As long as the after-tax dollars remain in the employer’s plan, all the investment earnings they generate will be tax-deferred. That is better than having the money in a regular, taxable investment account where earnings are taxed each year, because tax deferred compounding allows money to grow faster.
But it gets better than just tax deferred compounding. Upon retirement, or changing employment, taxpayers can take advantage of rules that allow them to roll over their pre-tax 401(k) assets into a traditional IRA, and the after-tax 401(k) assets to a Roth IRA in an effective tax-free Roth conversion.
Once the after-tax contributions made to a 401(k) plan are converted to a Roth IRA, investment earnings are not only tax-deferred, but are entirely tax-free if they are left in the account long enough. The strategy is simple and the tax cost is zero. It works like this:
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Max out the pre-tax contributions to a 401(k) plan every year
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Max out the after-tax contributions to a 401(k) plan every year
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Upon retirement or a change of employment, rollover the pre-tax contributions to a traditional IRA
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Upon retirement or a change of employment, rollover the after-tax contributions to a Roth IRA
With the issuance of IRS Notice 2014-54, the IRS approved of the strategy to split the pre-tax and after-tax funds and isolate the basis for the conversion to a Roth IRA. The new rules allow you to separate out your pre-tax contributions, sending them to a traditional IRA, from your after-tax contributions, sending them to a Roth IRA.
Benefits to the Taxpayer
Tax-Free Rollover
The transfer to the traditional IRA is a tax-free rollover that produce tax-deferred investment earnings. The transferred amount and the investment earnings will be taxable when withdrawn.
Tax-Free Conversion
The transfer to your Roth IRA is a tax-free conversion that produce tax-deferred investment earnings. If left in the account long enough, the transferred amount and the investment earnings will be tax-free when withdrawn.
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