A few years ago, the IRS released regulations easing the tax burden on after-tax contributions in a retirement account. Many clients don’t understand the rules governing after-tax contributions and may equate this contribution option with the Roth option. The tax rules are quite different and its important advisors be able to explain the differences.
Differentiating the Contribution Options
While almost all clients realize they have the ability to defer up to the traditional annual pre-tax contribution limit to a 401(k) plan ($18,000 in 2017, or $24,000 for clients age 50 and over) and up to the individual limit to IRAs and Roth IRAs ($5,500 or $6,500 with the catch-up), many don’t truly understand how the after-tax contribution comes into play.
The after-tax contribution rules allow the client to defer more than the annual pre-tax limit (for a total of up to $54,000 or 100 percent of compensation in 2017) to their traditional 401(k). While these contributions are made with after-tax dollars, they are not the same as Roth contributions (which also come from after-tax funds, and are discussed below).
Like pre-tax contributions, after-tax contributions cannot be withdrawn from the 401(k) without penalty except according to the terms of the plan (which will typically allow for penalty-free distributions only in the event of the client reaching age 59 ½, dying, retiring, becoming disabled or upon the occurrence of certain hardships).
Evaluating the After-Tax Option
The primary difference between the after-tax 401(k) contribution and the Roth contribution is the tax treatment of earnings on the client’s investment. While all Roth contributions are permitted to grow on a tax-free basis (i.e., the entire amount of the withdrawal will generally be tax-free), earnings on after-tax contributions will eventually be taxed at the client’s ordinary income tax rates.
As a result, only clients who are already contributing the maximum pre-tax and Roth amounts to their retirement accounts should consider the after-tax contribution option (generally, these will be high net worth clients seeking to amass a larger retirement nest egg). Clients should also consider maximizing their HSA contributions (which are contributed on a pre-tax basis, grow tax-free and can be withdrawn tax-free to cover medical expenses) before considering after-tax 401(k) contributions.
This is because the actual benefit of the after-tax contribution is tax-deferred investing and the eventual ability to move the after-tax funds into a Roth account, from which point they will grow tax-free. Both Roth accounts and HSAs allow the funds to grow tax-free from the beginning, which will maximize the value of the contribution through compounded earnings over time.