Why should you consider saving Non-Roth After-Tax Contributions into your 401(k)?
The key to maximizing your returns after all taxes, fees, and expenses.
Tax mitigation is an important strategy in financial planning. In the article I wrote last month, you read a quote from Thornburg Investments on a hypothetical model that showed how taxes reduce returns on equities by 1.58%. (Click here to read last month's article.) Thus, the goal we always have for our clients is to maximize their returns after all taxes, fees, and expenses. More often than not, the key to maximizing returns is using proper tax planning.
The easiest way to reduce the 1.58% tax drag on investment performance is to avoid the taxes altogether. Assuming a 401(k) plan allows for distributions of only after-tax money at any time and at any age, we can achieve that goal by ensuring all qualified retirement savings options are being utilized. When I discuss this with clients, their concern is that they are already maxing out their 401(k) contribution ($18,000 or $24,000 if over the age of 50) and they do not know where else to save tax-deferred. Previously, I discussed the Backdoor Roth savings strategy (click here to read) as a way to increase retirement savings. Today, I want to illustrate how after-tax 401(k) contributions, coupled with a Roth conversion, is an option for increasing retirement savings.
Many 401(k) plans allow employees to contribute non-Roth after-tax money to the plan over and above the $18,000 or $24,000 pre-tax limit. At first glance, non-Roth after-tax money in a 401(k) plan does not appear as beneficial as pre-tax money because the contribution is already taxed, grows tax-deferred, and the growth (over and above the contribution) is taxed at ordinary income rates when it is distributed. This is why we always encourage our clients to max out the $18,000 or $24,000 pre-tax limits before contributing non-Roth after-tax money to their 401(k) plan.
After maxing out the pre-tax limits, it is important to consider contributing non-Roth after-tax money to the 401(k) plan. It is also important not to invest the non-Roth after-tax money in the 401(k) plan since any growth in the account is taxed when distributed. The non-Roth after-tax contribution source can be converted to a Roth IRA while still employed by using an in-service distribution or in retirement by rollover. In a Roth IRA, both the contribution as well as all earnings grow tax-free and withdrawals will also eventually be tax-free. The 1.58% tax drag on performance is eliminated as long as the money is growing in a Roth IRA versus a taxable brokerage account. We base this under the assumption that the plan allows distributions of only after-tax money at any time and at any age.
A tough question one might ask is, how much non-Roth after-tax money can be contributed to a 401(k)? The only rule written out in IRS code states that contributions from all sources, including employer and employee, must be under $53,000 (or $59,000 if over the age of 50.) The problem arises when individual companies choose to restrict the amount allowed for contribution into the non-Roth after-tax source in the 401(k) plans. Some plans allow only $8,500 to be contributed per year, while other plans allow you to max out the IRS total contribution limits. Again, we base this under the assumption that the plan allows distributions of only after-tax money at any time and at any age.
*Please note that these numbers are based on the 2016 limits and have since been changed.