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Have You Actually Maxed Out Your 401(k)? Thumbnail

Have You Actually Maxed Out Your 401(k)?

The first goal for many retirement savers is to max out their 401(k)s. 

And while you may think that you’re “maxing” the account, you might have another thing coming. 

Do you think that the maximum contribution limit to your 401(k) is $20,500 this year? Think again! That number is simply the maximum amount of your salary you can defer this year. 

By this point, you’re likely shrugging your shoulders and thinking, what’s the difference?

Have you ever heard about after-tax contributions to your 401(k)? No, not Roth contributions, after-tax contributions. 

After-tax contributions are an excellent way for high-earners to stash even more away for retirement and truly “max out” their workplace retirement plans.

What Are After-Tax 401(k) Contributions?

There are three ways for you to contribute to a 401(k): 

  • Pre-tax, 
  • Roth, and 
  • After-tax. 

Most people are familiar with the first two. Pre-tax (or tax-deferred) contributions are deductible in the year they are made and taxed on withdrawal. Roth contributions don’t get the up-front tax deduction but are withdrawn tax-free. These types of contributions are limited to $20,500 per year, and again, that’s where most people think it stops.

But, the true limit is what is called the annual additions limit. For 2022, that limit is $61,000. If you are over 50 years of age, you can add another $6,500 in “catch up” contributions for a grand total of $67,500.  If your salary deferral contributions and your employer’s match don’t reach that number, some plans allow you to make after-tax contributions to get there. 

What’s The Difference Between After-Tax and Roth Contributions?

Some people mistakenly think Roth contributions are “after-tax” because they are still subject to income tax before being put into the 401(k). There is a technical distinction between them, though, and it matters quite a bit.

Although both contribution types use after-tax dollars, their treatment inside the plan is different. One grows tax-free, while the other grows tax-deferred. 

With true after-tax contributions, your distributions are partially taxable. You can withdraw the amount of your original contribution tax-free (because you already paid taxes on it when you earned it), but the IRS will tax the growth. 

As an example, suppose you make a $10,000 after-tax contribution that grows to $15,000. You can take $10,000 tax-free, but you’ll have to include $5,000 in your taxable income.

This is different from Roth contributions because qualified distributions are entirely tax-free (as long as you follow the rules). 

After-Tax Contributions Open Many Planning Opportunities

Now that you understand the difference between Roth and after-tax contributions let's talk about planning opportunities with this unique savings tool. 

In many cases, you won’t want to simply leave your after-tax contributions sitting around in the 401k because the growth is tax-deferred. Don't fret; you have several options to get around that rule. 

The simplest option is an in-plan conversion. If your plan allows, you can convert all or a portion of your after-tax contributions into a Roth 401k. 

Why would you want to do that? 

Because once you convert the funds, they grow tax-free, just like any other Roth account. The catch? Any growth that happens on the after-tax contribution from the time you make it until you convert is taxable. If you are going to do an in-plan conversion, it’s better to do it immediately.

You can also roll funds over into a Roth IRA via a mega backdoor Roth IRA. A mega backdoor Roth is super similar to an in-plan conversion and may be the only conversion option if your plan doesn’t permit in-plan conversions.

Either option can be a good strategy for maximizing the long-term tax value of after-tax contributions. 

3 Reasons After-Tax Contributions Might Be Right For You

Do you need to be thinking about making after-tax contributions? 

That depends. They are particularly helpful for someone who:

  • Is a high-income earner who is already maxing their elective deferrals to a 401(k). After-tax contributions are a logical next step. 
  • Your plan allows for conversions or in-service rollovers. These options effectively give you a much larger Roth limit if you do it correctly.
  • You could benefit from more tax-efficient savings.

After-tax contributions open up additional opportunities to save for retirement, making it an important consideration. 

Do More With Your Surplus

As a higher income earner, you need to be saving more than most people to maintain your lifestyle in retirement. If you have a surplus, looking into after-tax 401k contributions is an excellent method to boost your retirement savings. 

If you want help looking into after-tax contributions and whether or not your 401(k) allows you to, give me a call, and I’ll help you get started.