When it comes to saving for the long-term, the 401(k) plan is the most common option for employees to build a nest-egg. However, not all 401(k) contributions are created equal.
Beyond the typical pre-tax contributions associated with 401(k) plans, some employer-sponsored 401(k) plans have started offering after-tax and Roth options. While variety is the spice of life, these new options could also make retirement planning more puzzling. So, what do you do if your 401(k) plan offers after-tax and Roth contribution options? To help you answer this question, we’ll demystify these options and explore their pros and cons.
The Classic Pre-Tax 401k Contribution
Pre-tax contributions are the bread and butter of 401(k) plans. They allow employees to contribute a portion of their salary to their 401(k) account before taxes are deducted. The immediate tax break of contributing reduces your taxable income, providing upfront savings. However, it’s a deferred tax arrangement, meaning the IRS will eventually take its cut when you start withdrawing funds in retirement. Employers will often provide matching contributions (money that matches the amount you contribute, usually up to 4 percent) as a benefit.
The After-Tax and Roth Twist
Some 401(k) plans go a step further by offering after-tax and Roth contributions.
With the after-tax option, the funds you’ve contributed have already been taxed. The beauty here is that this option has the potential to grow your funds tax-free. But there’s a catch. When you start making withdrawals, the earnings (that is, any growth that happens as a result of the money being invested in the market) on after-tax contributions are subject to tax. The original contributions, on the other hand, are not subject to taxes upon withdrawal.
The Roth option is similar to the after-tax option in that the contributions are made with post-tax dollars. However, unlike the after-tax option, the Roth option allows both your contributions and earnings to grow tax-free. You pay zero taxes on future Roth withdrawals, no matter how much the account grows.
The Benefits of After-Tax and Roth Contributions
Why consider after-tax and Roth contributions? The main benefit is that they offer you the ability to play the game of tax diversification. In other words, you give your future self the option to pull from taxable or non-taxable pots of money in retirement. None of us know what our tax rate will be like in the future, but as you get closer to retirement age, you might be able to see clearly that you’ll be spending a few years making no money at all and, as a result, in a very low tax bracket. A few years down the line, you may decide to work and generate some income, thus bumping yourself up into a higher tax bracket. It would make sense to pull money from your taxable pool of money in the no/low-earning years to pay a lower rate. In the years where your tax rate is higher, you could then draw from the non-taxable pool of money to support yourself. It can be really helpful here to consult with an accountant or financial planner to figure out the best strategy. We employ this a lot with clients in their later stages of life to help them save money on taxes that they would have paid if they pulled from the taxable buckets at the wrong time.
What's Better? After-tax or Roth?
On paper, the Roth option sounds like the clear winner. As long as you’re okay with paying more in taxes on your income now than you would if you were making pre-tax contributions, the Roth option makes your nest egg tax-free forever.
However, the Roth option isn’t necessarily right for everyone. While your Roth 401(k) contributions and earnings grow tax-free, keep in mind that if you’re making Roth contributions into a 401(k), they count toward your annual employee contribution limit of $23,000 (or $30,500 if you’re age 50 or over) as of 2024.
After-tax contributions don’t count toward the $23,000 employee contribution limit. Instead, they count toward the difference between the $23,000 employee limit and what’s called the combined employer/employee contribution limit. For 2024, the combined employer/employee limit is $69,000 per year or $76,500 if you’re age 50 or over. This means you can meet your $23,000 limit with either pre-tax or Roth contributions first, and then contribute the remaining $46,000 using the after-tax option. Any contributions made by your employer count toward the combined employer/employee limit of $69,000, not your employee limit.
In reality, most people don’t have the ability to save these large amounts of money out of their salaries. But the parameters are good to know about if you’re able to start saving more than the $23,000 limit. For instance, if you make a $125,000 salary and contribute 20% of your income to a 401(k), you’re already hitting the $23,000 employee limit before the year ends. Once you hit the limit, you could switch your contributions over to the after-tax option and keep adding to your 401(k) nest egg.
The Drawback of After-Tax and Roth
Even though both of these options have clear benefits, after-tax and Roth contributions aren’t without their drawbacks.
- The lack of an immediate tax break for both after-tax and Roth contributions means you’ll feel the pinch in your take-home pay.
- When you opt for after-tax and Roth contributions, you’re essentially betting on the tax benefits in retirement outweighing the lack of tax breaks today. Tax laws and rates can change, and so can your future income levels and tax brackets. This uncertainty adds a layer of complexity to retirement tax planning.
- It’s important to remember that the IRS imposes annual contribution limits on 401k plans , which encompass the total of pre-tax, after-tax, and Roth contributions. By choosing to allocate part of your employee limit to Roth contributions, you might be missing out on the opportunity to reduce your current taxable income through pre-tax contributions. For some, the immediate tax savings from pre-tax contributions could be more beneficial, especially if you’re currently in a high tax bracket and expect to be in a lower bracket in retirement.
- While after-tax contributions to a 401k plan can grow tax-deferred, the earnings on these contributions are subject to tax upon withdrawal. This creates a less favorable situation compared to Roth contributions, where both contributions and earnings can be withdrawn tax-free in retirement. Managing the tax liability on the earnings from after-tax contributions requires careful planning and consideration, especially when deciding whether to roll these funds into a Roth IRA. At that point, you’d need to pay the taxes on the earnings to convert them into the Roth IRA.
The Convenience Trick of Automatic Roth Conversions
Here’s where things get interesting. Some 401(k) plans offer a feature that’s as convenient as it is strategic: the automatic conversion of after-tax contributions to a Roth account within the plan. This nifty option saves you from the hassle of manually moving after-tax contributions to a Roth IRA to ensure tax-free earnings growth. It’s like having a financial butler who takes care of the tax efficiency of your retirement savings without you lifting a finger. You can check in on this by calling up your 401(k) provider, and asking if they can essentially “switch on” a setting so that all of your after-tax contributions immediately and automatically get converted to a Roth account.
Deciding between pre-tax, after-tax, and Roth contributions in your 401(k) plan is a delicate balance of tax efficiency, retirement goals, and immediate financial needs. By understanding the nuances of each option, you can figure out a long-term savings strategy that’s in perfect harmony with your financial goals. Navigating the world of 401(k) contributions can be complex, but with a clear understanding, you can leverage your employer’s retirement plan options to seriously boost your long-term nest egg.
Brandon Tacconelli is the Director of Client Care at Thinking Big Financial, Inc. Thinking Big is a fee-only financial planning firm in New York City specializing in working with the LGBTQ+ Community.