The Retirement Plan Option You Probably Have Never Heard Of

Did you know you can put additional after-tax money into your 401(k) or 403(b) above the normal $20,500 per year cap (or $27k if you’ll be age 50 or above this year)? The IRS limit for the total of all annual contributions is the lesser of $61k (or $67.5k if age 55 or older) or 100% of your compensation. 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. That makes Roth contributions clearly superior.

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 plan 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, 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a taxable account since earnings from the after-tax account are taxed at higher ordinary income tax rates when they’re withdrawn.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 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 taxable 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?

One really good tax reason to contribute to an after-tax account is the ability to convert it to a Roth account that can grow tax-free. (Don’t forget that you’ll still need to pay taxes on the after-tax earnings when you do so.) 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.

Does your retirement plan offer superior investment options?

Taxes aren’t everything. You might want to contribute more to your employer’s plan rather than a taxable account because it offers a unique investment opportunity that you want to take advantage of. That’s a valid argument for an after-tax account too.

After-tax contributions are obscure for a reason. Most people don’t really need them, and many retirement plans don’t even offer them. But if you’re maxing out your pre-tax and/or Roth contributions, have additional dollars to invest, don’t need the funds before age 59 1/2, and would like to invest the money in bonds, choose investments unique to your employer’s retirement plan, or eventually roll it into a Roth account, you might want to consider making after-tax contributions. Just don’t be surprised when no one else knows what you’re talking about.