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If you’ve reached your 401(k) annual contribution limit, you’re probably a super saver. The good news is, if you have more retirement dollars without a home, you may be able to add them to your 401(k) account using after-tax contributions. An after-tax 401(k) contribution is when you put money you’ve already paid taxes on into your 401(k) account to save more for retirement.
How after-tax 401(k) contributions work
Employees who have a traditional 401(k) plan at work can make contributions through payroll. Your annual contribution is capped at $19,500 in 2021 and $20,500 in 2022 (Those 50 and older can contribute an additional $6,500 in catch-up dollars). Your employer might match a percentage of your contribution to beef up your savings.
This is where after-tax 401(k) contributions come in handy. If your contribution, plus any employer match you get, doesn’t add up to the overall annual limit — $58,000 in 2021 and $61,000 in 2022 — you may be able to make after-tax contributions to your 401(k) to get to that amount.
Vanguard’s How America Saves 2021 report states 10% of people who had access to after-tax 401(k) contributions made them, and they tended to have higher incomes. So if you’re a high earner, this could be a good option for you because unlike the Roth IRA, there are no income restrictions on after-tax 401(k) contributions.
Let’s put these numbers into perspective using an example.
Rachel earns $100,000 and has a 401(k) account at work. She contributes $19,500 in 2021, maxing out her annual 401(k) contributions. Her employer offers a 100% employee match, up to 6% of her annual salary, which comes up to $6,000. This means Rachel now has $25,500 in her 401(k). Because the overall annual 401(k) limit for 2021 is $58,000, and because her employer’s 401(k) plan allows for after-tax contributions, she can put an additional $32,500 in after-tax dollars to her 401(k).
Benefits of after-tax contributions
Using 401(k) after-tax contributions to save for retirement can be beneficial, especially for people in higher tax brackets, says Christine Benz, Chicago-based director of personal finance at investment research firm Morningstar. (Morningstar is a NerdWallet partner.)
“High-income people who have run out of receptacles to save in, they should absolutely take advantage of this maneuver,” she says.
You can also withdraw your after-tax contributions without penalty or taxes. However, if you withdraw the earnings from those contributions, you may have to give Uncle Sam his fair share. If you’re younger than 59½, you may also have to pay a 10% penalty.
Not every employer provides an after-tax 401(k) contribution option, so check to see if it’s something you have access to. According to the Vanguard report, in 2020, 19% of Vanguard 401(k) plans had an after-tax contribution option.
Strategies for after-tax 401(k) contributions
We’ve established that you may be able to fatten up your 401(k) by adding after-tax contributions. But there is one caveat: Any earnings you make on those contributions are taxable. To minimize your taxes, you can consider rolling your after-tax contributions into a Roth IRA and the earnings into a traditional IRA (more on this later).
» Use our cheat sheet to learn about the IRA rules
Put contributions into a Roth
You may be able to put your after-tax contributions into a designated Roth account to ensure tax-free withdrawals during retirement. That is, as long as you wait until age 59½ to withdraw, and you make your first contribution at least five years before then.
There are two ways you can roll after-tax contribution dollars into a Roth account:
In-plan conversion: If your job offers an in-plan conversion, you can convert all or some of your 401(k) into a Roth. You have to pay taxes on the amount you convert, but like with a Roth IRA, your withdrawals in the future would be tax-free. Some plans have an auto-convert feature that automatically converts your after-tax contributions into your Roth.
In-service withdrawal: If your employer offers in-service distributions or withdrawals, you can do a mega backdoor Roth. This is when you roll after-tax contributions into a Roth IRA outside of your retirement plan.
If your employer doesn’t offer in-plan conversions or in-service distributions on your 401(k) plan, you might consider asking what your options are for withdrawing money and putting it into an IRA. Make sure to ask about the rules associated with withdrawing money from your 401(k) and any potential penalties.
» Learn more about taxes on 401(k) withdrawals and contributions
Split between a traditional and Roth IRA to defer taxes
If you want to defer paying taxes on your after-tax contribution earnings, you can put the after-tax dollars into a Roth IRA because you’ve already paid taxes on it, and put your earnings into a traditional IRA. If you choose to split your contributions this way, you pay taxes on the earnings whenever you withdraw the money from your traditional IRA.
Let's say in 2020 you made a $30,000 after-tax contribution to your 401(k). At the end of the year, when you check your account, you realize you made $1,000 in earnings. You could either roll the total sum, $31,000, into a Roth IRA and pay taxes on the $1,000 you earned, or you could put $30,000 in a Roth IRA and $1,000 into a traditional IRA. If you choose the latter, you don’t have to pay taxes until you withdraw from your traditional IRA during retirement.
» Dig deeper into tax-efficient investing
Are after-tax 401(k) contributions right for me?
If you’re a high earner and have maxed out your pre-tax 401(k) contributions, putting after-tax dollars into a 401(k) might be a good option for you to boost your retirement savings.
If you want investments to grow tax-deferred for retirement and would rather not open a brokerage account, this could fit your needs. Why might 401(k) after-tax contributions be better? “It tends to be a little more tax-efficient to save within the after-tax 401(k) because you’re getting the tax-free compounding and then the tax-free withdrawals in retirement, whereas if you have a taxable brokerage account, at a minimum, you’re paying some capital gains taxes when you sell appreciated securities,” says Benz.
If you decide not to do a rollover because your employer doesn’t offer in-plan conversions or in-service distributions, think carefully about whether after-tax contributions are right for you. If you leave your after-tax contributions to grow tax-deferred in your 401(k), you’ll have to pay taxes on any earnings once you withdraw them.
Benz says this type of retirement investing isn’t right for everyone.
“I think a key piece of advice is, unless you’re already making the fully allowable contribution to either a traditional or Roth 401(k), don't even think about after-tax 401(k) contributions. The other type of contributions will be more attractive from a tax standpoint than will be the after-tax 401(k).”
» Find the best Roth IRA accounts to roll your after-tax contributions into