With so many options available, lots of people get confused when setting up a retirement plan. Everyone wants to save the most amount of money for their golden years but without getting hit with hefty taxes or penalties. One thing you should consider is whether adding after-tax contributions to your plan makes sense.
If you work for an organization that matches contributions, count yourself lucky. In this case, you want to contribute the most possible to your retirement plan. That way, you’ll receive a full matching contribution from your employer.
If you’re in good financial standing, you can do even more to reach financial freedom. As an example, you could put additional money aside from your paychecks.
Contribution Limits for Your 401(k)
For 2020, the Internal Revenue Service (IRS) set the limit for salary deferrals to a 401(k) retirement plan at $19,500. However, if you’re 50 or older, you’re allowed an additional $6,500 as catch-up money. From last year, that’s an extra $500 for both, bringing the amount you can defer from $19,000 and $6,000, respectively.
You may not realize that you have other options for building up your retirement plan. In 2019, the total defined contribution, coming from both you and your employer, was $56,000 and $6,000 in catch-up money. For 2020, that’s increased to $57,000 and $6,500. Not only does that include what you’ve contributed through salary deferrals, as well as what your employer contributed, but also whatever money you’ve chosen for an after-tax contribution.
Reasons to Save After-tax Contributions to a Defined Plan
Not everyone’s in a position to max the pre-tax contributions to their retirement plans. If you’re in a place where you work for a company that matches contributions and you can hit the maximum allowed, there are bona fide reasons why it makes sense to save additional money through your after-tax contributions going to your 401(k) plan. Keep in mind, this also works for defined contribution plans outside of a 401(k).
If you need to extract money from your after-tax voluntary contributions, you can. Of course, that means abiding by the plan’s guidelines for withdrawals. As you know, life often throws us curveballs. If an emergency arises, this is an excellent way to get your hands on those funds.
For this, there are a couple of things to factor in. For one, there’s a chance you wouldn’t be able to withdraw associated earnings growth. Even if you can, you’d have to pay taxes. Along with that, if you take money out before reaching 59.5 years of age, you’d have to pay a 10 percent penalty. Remember, this applies only to associated earnings growth as opposed to your original contributions.
Another advantage of having a retirement plan with matching contributions coming from your employer is that the overall process is a breeze. With this, you can have the money taken out of your paychecks automatically. Other than set up the plan initially, you don’t have to do anything.
You simply determine the amount of money you want to contribute and the way you want it invested. Typically, the options for making an investment are no different than what you would do for a Roth or pre-tax account.
Tax-free Rollover Eligibility
Something else to consider is the option for a tax-free rollover. Usually, you’d decide on this when leaving employment with the company you work for or upon retirement. At that point, the account balance in your after-tax retirement plan will have two components.
- The original after-tax contributions
- The tax-deferred earnings growth associated with the original contributions
During the rollover process, the IRS will let you separate the two. Why does that matter? Well, again, when you leave the company you work for or retire, you can opt to roll the tax-deferred earnings growth into an IRA. Then you can roll the after-tax contributions into a Roth IRA.
The value of this is that any future earnings growth might be tax-free as long as you leave the money in a traditional IRA until you hit 59.5 years of age. This is because the IRS deems the money as pre-tax amounts.
For instance, let’s say you’ve contributed the maximum limit of $19,500 into your pre-tax 401(k) retirement plan. Let’s also say you’re in a position to save an extra $12,000 via after-tax contributions that would go into the same plan. In 10 years, you’d have $120,000 in contributions and $40,000 in growth for a total of $160,000 coming from your after-tax contributions.
Using the same scenario, assume you have $250,00 in both pre-tax savings and earnings growth. At the time you leave your employment for a new job, or you retire, you have the option of rolling the balances of your after-tax voluntary retirement plan into two distinct accounts. Therefore, you’d have after-tax contributions of $120,000 to go into a Roth IRA.
Ultimately, you’d have $290,000. That’s the $40,000 in growth coming from the contributions in addition to the $250,000 from your pre-tax 401(k). You could put that money into a traditional IRA or if you take another job, add it to a new defined contribution retirement plan through your employer.
Again, looking 10 years down the road, if the Roth IRA offered an annual return of 7.2 percent, there’s a good chance the account would double in value. That’s without making any other contributions. In other words, you’d have an extra $120,000 of growth that’s tax-free simply by putting after-tax money into the retirement plan at the company you work for.
Seek Professional Advice
Although this process is easy, there are always questions involved. To ensure your money works hard for your retirement, it’s always best to consult with a qualified financial expert. There are also great do-it-yourself tools out there that you can use. The best tool for consumers for retirement planning that we have found is WealthTrace. The WealthTrace planner allows consumers to run scenarios such as: Can I retire earlier if I make after-tax contributions to my 401(k)?
Whether you seek out a financial planner or you do it yourself, make sure the planning software is robust and accurate, otherwise the results can lead you to make bad decisions.