This post has been updated to reflect changes to the program for 2021.
In 1978, the United States Congress dramatically altered the way Americans planned for retirement with the creation of the 401(k). Prior to 1978, many companies offered pensions intended to provide a lifetime paycheck for long-term employees.
From Pensions to 401(k)s
Since then, the onus of saving and growing retirement assets has shifted more and more to the individual. Although this shift gives people control over their financial future, it also comes with some complexities.
Wage-earners can put away up to $58,000 ($64,500 for those age 50 or older) per year into a 401(k) plan. That figure is quite different than the basic deferral amount—$19,500 ($26,000 for those 50 and older)—most people focus on when saving for retirement. You can close the gap between the two with employer-matching contributions, profit-sharing contributions, and after-tax contributions.
The first goal for those building a nest egg is to max out the standard deferral of $19,500 plus any applicable catch-up amount. You can allocate those deferrals to either a traditional tax-deferred account or, if your plan allows, a tax-exempt Roth account.
For example, if an employer matches 50 percent of employee contributions up to the federal limit, that is another $9,750 in 2021 in contributions to your 401(k). That comes to $29,250 in retirement contributions for the year, a significant amount to be putting away for future needs. However, there would still be $28,750 of room to contribute additional dollars to your account.
After-Tax 401(k) Contributions
More employer plans now feature after-tax 401(k) contributions, which allow employees to close the savings gap noted above. The after-tax contributions are not tax-deductible, and only your basis (the sum of your contributions) can be withdrawn tax-free in the future.
In the past, the terminology of after-tax contributions was applied incorrectly to Roth contributions where both your contributions and future growth were accessible on a fully tax-exempt basis in the future. Now, with more plans offering true after-tax contributions, it is important to delineate the two types and their tax treatment.
There are some essential facts to keep in mind:
- Your after-tax contributions can be rolled into a Roth IRA upon separation from your employer. They will continue to grow on a tax-exempt basis.
- You can benefit from continued tax deferral by rolling over any growth in your after-tax 401(k) into a traditional IRA. This key point is what differentiates a Roth from an after-tax contribution.
- Some plans allow for in-service distributions directly to Roth IRAs of your after-tax contributions. This is sometimes called a mega back door Roth
Conclusion
Whether contributing to an after-tax 401(k) makes sense for you depends on current needs, cash flow, and the makeup of your balance sheet. With many Americans woefully underfunded for retirement, utilizing your after-tax 401(k) contributions, if available, is a great way to make up for lost time.
If you have any questions around advancing your life plan and aligning your wealth to your vision and values, we are here to help.
Steven Hanks, CFP® serves as an advisor at Brighton Jones.
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