Shot of a couple going over paperwork together at home
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Are you maxing out your employer’s retirement plan contributions? Did you know you might be able to put additional money into your plan after-tax? (The 2021 annual IRS limit for the total of all annual contributions is the lesser of 100% of your compensation or $58k plus $6,500 if you’re age 50 or older.) If you check with your retirement plan provider, you may be surprised to discover that this option is available. Here are some factors to help you decide if it’s an option worth considering.
Are you maxing out your pre-tax and/or Roth contributions?
You’ll probably want to make sure that you’re maxing out your pre-tax or Roth contributions first. Roth contributions are also after-tax, but the earnings are tax-free after age 59 1/2 as long as the account has been open for at least 5 years. In contrast, earnings on after-tax contributions are still taxable when you withdraw them.
As for pre-tax contributions, the only way that after-tax contributions can come out ahead is for your tax rate to be significantly higher when you make withdrawals. In that scenario, you might be better off paying the tax on the contributions now rather than later. But you have to ask yourself how likely that is, considering that people typically have less income in retirement and a lot of your retirement account withdrawals may be taxed at lower brackets. In addition, that benefit is at least partially offset by the fact that you can afford to save more pre-tax since those contributions have a smaller effect on your paycheck than after-tax contributions, which reduce your paycheck dollar-for-dollar.
Would you end up paying more taxes and penalties in the after-tax account?
Even if you’re maxing out your pre-tax or Roth contributions, you still might be better off putting money in a taxable account for a couple of reasons. First, under current tax law, you’ll end up paying a lower tax rate on long term capital gains (except maybe on collectibles) in a taxable account since earnings from the after-tax retirement account are taxed at higher ordinary income tax rates when they’re withdrawn. This is less of an issue if you invest the after-tax account in bonds since the interest is taxed at ordinary income rates anyway.
Second, a taxable account provides more flexibility as you can withdraw all your money anytime and for any reason without worrying about early-withdrawal penalties. On the other hand, even if your retirement plan allows you to withdraw from the after-tax account, a pro rata percentage of your withdrawals would be considered earnings and possibly subject to a 10% penalty if you’re under age 59 1/2. This is an important factor if you might need the money before then.
Would you like to contribute more to a Roth?
There is one really good tax reason to contribute to an after-tax account though. That’s the ability to contribute additional dollars into your retirement plan that can later be rolled or converted into a Roth account, which can then grow to be tax-free after 5 years and age 59 1/2. (This is often called a mega-backdoor Roth.)
If your employer offers you a Roth option, you might even be able to convert it to a Roth while you’re still working there. Otherwise, you can roll the after-tax money into a Roth IRA, which gives you more investment flexibility and the option of withdrawing the converted amount tax and penalty-free at any time. (The earnings can be rolled into a pre-tax traditional IRA.)
Does your retirement plan offer superior investment options?
Taxes aren’t everything. You might want to contribute more to your retirement plan rather than a taxable account if it offers a unique investment opportunity that you want to take advantage of or mutual funds for a lower cost than you can purchase outside. These are valid arguments for an after-tax account too.
Still not sure if after-tax contributions make sense for you? Consider consulting with an unbiased and qualified financial planner. Your employer may even offer access to some for free through a workplace financial wellness program.