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Chris Brennan, CFP®

Many individuals aim to maximize their retirement savings, yet oftentimes find themselves in a position whereby they have exhausted all of their “advantaged” retirement savings capabilities. For some, that simply means contributing as much as they can to a 401(k) or 403(b). Others might also have access to a 457 plan that allows for contributions over and above the 401(k) and 403(b) limits.  Roth IRAs, with a $6,000 contribution limit in 2021 ($7,000 if age 50 or older), are also popular savings vehicles if one qualifies.  But after all of these avenues are exhausted, many savers merely contribute to a taxable investment account (trust account, joint account, etc.), with no real tax advantages.  If an individual has the ability to make “after-tax” contributions to his or her 401(k) or 403(b), it would be worth their while to explore the possibility.   

So long as their employer offers a 401(k) or 403(b), most individuals are eligible to contribute to a retirement plan. The 2021 contribution limit in most cases (regardless of income) is $19,500 ($26,000 if age 50 or older), meaning an individual is able to have $19,500 taken out of their paycheck on a pre-tax or Roth basis and contributed directly into a 401(k) or 403(b).  Over and above the $19,500, many employers will provide some sort of matching contribution.  Lastly, there may be a profit-sharing, or discretionary, contribution made by an employer.  Cumulatively, these three contributions can total no more than $58,000 ($64,500 if age 50 or older) in 2021; and herein lies the opportunity with after-tax contributions.  

If the employee contributions, as well as any employer matching and profit-sharing/discretionary contributions, do not amount to the $58,000 limit, after-tax contributions (if allowed) are a fantastic opportunity for many individuals looking to set aside more dollars for retirement.        

After-tax contributions to a 401(k) or 403(b) look a lot like Roth contributions to a 401(k) or 403(b).  Both contributions are made with post-tax dollars.   However, there is one important distinction – the growth associated with after-tax contributions (unlike the growth associated with Roth contributions) is subject to income tax upon distribution from a retirement plan.  So if an individual contributes $50,000 to the after-tax “bucket” within their 401(k) throughout the course of his or her career, and by the time they retire the value of the after-tax bucket is $300,000, then $250,000 would be taxable upon distribution.  The good news is that this may be easily avoided in many cases. 

Most plans that permit after-tax contributions also allow in-service rollovers or in-plan conversions.  So if an individual is interested in making after-tax contributions, but also wants to limit their tax liability, they can request a rollover of the after-tax dollars within their 401(k) or 403(b) to a Roth IRA intermittently throughout the course of their career (even while they’re still employed).  

The plan might also allow for in-plan conversions, which convert all or some of the dollars residing in the after-tax bucket to the Roth bucket.  Importantly, any growth associated with the dollars involved in a rollover or conversion ($10,000 of contributions may have grown to $11,000 in value) will be taxed as ordinary income as a result of a rollover/conversion.  Even still, most people would be happy to pay the tax associated with $1,000 of growth today to avoid paying the tax associated with $250,000 of growth 20 or 25 years from now.  

To further illustrate how this might benefit someone, let’s assume a 45 year-old individual contributes $19,500 to their Roth 401(k) throughout the course of 2021.  Over and above the $19,500, their employer contributes another $14,500 to their 401(k) via matching and profit-sharing contributions.  Collectively, $34,000 is contributed to their 401(k) throughout the course of the year.  In the event their plan allows for them, they would be able to contribute an additional $24,000 to the plan via after-tax contributions (taking into account the $58,000 limit referenced above).  So rather than saving an additional $2,000/month in a taxable investment account, they will be able to allocate a significant amount of additional savings to their 401(k).  And by then rolling these dollars into a Roth IRA (or performing an in-plan conversion), the growth associated with these contributions will be tax-free.  Therefore, they will have effectively increased the limitation on Roth IRA or Roth 401(k) contributions from $6,000 or $19,500 (in 2021) to $30,000 or $43,500, respectively.  

Also of note, for self-employed persons with individual 401(k)s, the ability to contribute on an after-tax basis can be included in your plan document.  Importantly, after-tax contributions will offset the ability for one to make additional profit-sharing contributions (which are pre-tax), which is oftentimes one of the primary motivators for individuals who establish individual 401(k)s – tax deferral.   

This opportunity is one that many individuals ought to explore, especially those who desire to save above and beyond typical 401(k) or 403(b) contributions.  It is also important to determine what their employer allows.  And if the right circumstances exist, we encourage people to engage with their trusted advisors to determine whether or not after-tax contributions are appropriate for them. 

Chris Brennan, CFP®, with MAI Capital Management, LLC, can be reached at 513.579.9400 or by email at chris.brennan@mai.capital.


DISCLOSURE:

This interview has been prepared for informational purposes only. The opinions and analyses expressed herein are subject to change at any time.  Any suggestions contained herein are general and do not take into account an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change.  Distribution hereof does not constitute legal, tax, accounting, investment or other professional advice.  Recipients should consult their professional advisors prior to acting on the information set forth herein.  Under certain Treasury Regulations, we inform you that any federal tax conclusions outlined in this communication, were not intended or written to be used, and cannot be used by any taxpayer, for the purposes of avoiding penalties that may be imposed by the Internal Revenue Service.

MAI Capital Management (“MAI”) is a fee-based registered investment adviser and wealth management firm based in Cleveland, with additional offices in Cincinnati, OH, Ponte Vedra Beach and Naples, FL, Nashua, NH, Irvine, CA, Reston, VA, Little Rock, AR, New York City and St. Louis and a presence in Columbus, OH and Miami.  MAI’s Cincinnati office is located at 625 Eden Park Drive, Suite 310, Cincinnati, OH 45202.  For more information, call 513.579.9400 or visit www.mai.capital