After-Tax 401(k) Contribution

Written by True Tamplin, BSc, CEPF® | Reviewed by Editorial Team

Updated on December 13, 2022

What Is an After-Tax 401(k) Contribution?

An After-Tax 401(k) Contribution is a retirement savings option that involves contributing money that has already been taxed into an employee’s 401(k). This strategy is possible whether the employee’s core 401(k) plan is under a traditional or Roth setup. 

After-Tax 401(k) Contributions are similar to Roth retirement plans because when employees withdraw these contributions upon retirement, they will no longer pay income taxes. 

However, they will still have to pay income taxes on any earnings they withdraw, which they need to reflect on their Internal Revenue Service (IRS) Form 1040.

As a retirement planning tool, after-tax 401(k) contributions are often utilized by individuals who have maxed out their employee contribution limit for their core 401(k) plan. This is also a good option for high earners who would like to save more for retirement. 

How After-Tax 401(k) Contributions Work

Employees who wish to make after-tax contributions to their 401(k) can arrange for their employers to make direct paycheck deductions. 

After income taxes have been subtracted from the employee's salary, their after-tax 401(k) contributions will be transferred into their core 401(k) account.

Unlike regular contributions to a core 401(k) plan, this alternative is not subject to the employee's contribution limit. Instead, it will be counted as part of the total contribution limit, which includes any employer contributions. 

Core 401(k) plans have an employee contribution limit of $22,500 in 2023, which has increased from the 2022 limit of $20,500. Employees who are 50 years old and older can make additional catch-up contributions of up to $7,500 in 2023 or  $6,500 in 2022.

Meanwhile, the total contribution limit for core 401(k) plans in 2023 is $66,000 or $73,500 for those 50 and older. This has increased from the 2022 limits of $61,000 or $67,500, respectively.

The gap between the employee contribution limit and the total contribution limit may be filled in by employer contributions and after-tax 401(k) contributions.

If an employee has reached the contribution limit to his core 401(k) plan and received the highest employer contribution possible, the after-tax 401(k) can be very useful.

It must be noted that after-tax 401(k) contributions are not tax deductible since they have been made with post-tax dollars. 

Instead, these contributions can be withdrawn tax-free anytime. However, earnings will still be taxed as ordinary income upon withdrawal, even if this was done after retirement.

How_After-Tax_401(k)_Contributions_Work

Benefits of After-Tax 401(k) Contributions

Making after-tax 401(k) contributions to a core 401(k) brings several advantages. 

  • Direct Paycheck Deductions: Just like regular contributions to their core 401(k), employees can request their employers to deduct their after-tax contributions from their paychecks. This makes the process simpler and helps them stay on their savings target.
  • Tax-Deferred Earnings: After-tax 401(k) contributions can be withdrawn anytime tax-free. Meanwhile, the earnings gained from these investments are allowed to grow tax-deferred, meaning employees will only pay income taxes upon withdrawal.
  • Increased Maximum Contribution Limit: After-tax 401(k) contributions allow individuals to increase their retirement savings without being restricted by the core 401(k) plan's employee contribution limits.
  • Flexible Withdrawals: With an after-tax 401(k), individuals can withdraw their contributions whenever they want, as opposed to a core 401(k) where stricter withdrawal rules apply. This gives employees more freedom with their money.
  • Plan Portability: Just like regular 401(k) contributions, after-tax 401(k) contributions can also be transferred to another plan if individuals leave their current employer.
  • Option to Roll Over to a Roth IRA: Individuals can roll over their after-tax contributions to a Roth Individual Retirement Arrangement (Roth IRA). Doing this will make the withdrawal of earnings tax-free, provided that specific rules are followed.
  • No Income Limits: After-tax 401(k) contributions can be made by anyone, regardless of income level. As long as their employer offers the core 401(k) plan, each employee is eligible to make after-tax contributions.

Benefits_of_After-Tax_401(k)_Contributions

Drawbacks of After-Tax 401(k) Contributions

Making after-tax 401(k) contributions also comes with several drawbacks, including the following:

  • Limited Investment Options: Employers offering a 401(k) plan may decide where their employee’s contributions go by default. Employees could also revise their investments, but often they may have to choose only from the other options offered in the plan.
  • Complex Rollover Process: Although rollover options covering after-tax 401(k) contributions are possible, they involve a complex process that must be followed so that individuals can avoid penalties.
  • Taxable Earnings: Another drawback of 401(k) contributions is that individuals have to pay taxes on their earnings. Even though employees do not have to pay taxes immediately; eventually, their earnings will be taxed as ordinary income upon withdrawal.

Drawbacks_of_After-Tax_401(k)_Contributions

How to Roll Over After-Tax 401(k) Contributions to a Roth IRA

Without being penalized, you can roll over after-tax 401(k) contributions to a Roth IRA upon retirement or job change. However, this is a complex process you can typically only accomplish once you have separated from the employer that sponsors your core 401(k) plan.

 As an IRS rule, you must roll over your 401(k) contributions in direct proportion to what you already have in the fund. 

For example, if you have $100,000 in your account and it was funded by $90,000 in pre-tax contributions and $10,000 after-tax contributions, the amount you transfer must be composed of 90% pre-tax money and 10% after-tax money. 

Once you have determined the amount you wish to transfer, your plan administrator will send you two checks: one for the after-tax contributions and one for the pre-tax ones. While you can choose to deposit both into a Roth IRA, depositing them into separate accounts is advisable.

For instance, you can deposit the after-tax contribution check directly into a Roth IRA account while rolling over the pre-tax money into a traditional IRA. To do this, you must fill out the 401(k) distribution paperwork and indicate which account will receive which type of contribution.

If you want your rollover to be valid, you have 60 days from receiving the checks to deposit them into the correct accounts; otherwise, they will become taxable. 

However, there is no rush to start the rollover since there is no time limit on a 401(k) plan’s portability. Thus, even after leaving your employer, you can wait until you are ready to decide what to do with your 401(k) account balance.

Other Rollover Alternatives

There are other alternatives besides rolling over after-tax 401(k) contributions to a Roth IRA if you are retiring or separating from a company. 

You could choose between rolling the funds into a traditional IRA, moving them into a new company's 401(k) plan, or leaving them where they are.

First, you may roll over both your pre-tax and after-tax 401(k) contributions into a traditional IRA. Traditional IRAs allow you to grow your pre-tax contributions without taxing them until you are asked to take required minimum distributions (RMDs) at age 72. 

However, since your traditional IRA account will also contain after-tax money, you must file IRS Form 8606 annually to ensure that withdrawals of your after-tax contributions will not be taxed. 

You must continue to file this form until you have consumed your entire after-tax balance. 

For your next option, you can transfer your pre-tax and after-tax 401(k) contributions into your new employer's 401(k) plan. This enables you to combine all your 401(k)s into one account, making it easier to track your retirement savings. 

Finally, you may also leave your funds exactly where they are. With this option, the funds in your previous 401(k) plan will continue to grow. However, you will not be able to make additional contributions in the future. 

When deciding between different rollover options, you can take your time, talk with a financial advisor, and discover the most appropriate course of action for your specific situation.

The Bottom Line

An After-Tax 401(k) Contribution is a retirement savings option that involves contributing money that has already been taxed into an employee's 401(k). This strategy is possible whether the employee's core 401(k) plan is under a traditional or Roth setup.

Like Roth retirement plans, employees will no longer pay taxes when they withdraw after-tax 401(k) contributions upon retirement. However, they will still have to pay income taxes on any earnings they withdraw.

Unlike regular contributions to a core 401(k) plan, this alternative is not subject to the employee's contribution limit. Instead, it will be counted as part of the total contribution limit, which includes any employer contributions. 

After-tax 401(k) contributions come with their pros and cons. Some of the benefits include tax-deferred earnings and an increased maximum contribution limit. However, there are also some drawbacks, such as limited investment options and a complex rollover process. 

One of the best features of after-tax 401(k) contributions is that employees do not need to worry when they leave the employer sponsoring their core 401(k) plan. This is because they may transfer these funds into other retirement savings plans, such as a new 401(k) or a Roth IRA, 

Overall, if an employee has reached the maximum contribution limit to his core 401(k) plan and received the highest employer contribution possible, the after-tax 401(k) can be a promising strategy for those who wish to save more for retirement.

FAQs

Is it worth contributing to after-tax 401k?

If you have reached the maximum contribution limit to your core 401(k) plan, received the highest employer contribution possible, and still wish to save more for retirement, after-tax 401(k) contributions can be worth investing in.

What is the difference between Roth 401k and after-tax 401k?

Individuals will not pay taxes when they withdraw contributions from either a Roth 401(k) or an after-tax 401(k). However, they will still have to pay income taxes on any earnings they withdraw from after-tax 401(k) contributions. In contrast, earnings from a Roth 401(k) can be withdrawn tax-free after the individual reaches 59 ½ years old and completes the five-year holding period.

Can you transfer only the after-tax portions of your retirement plan to a Roth IRA and leave the rest in your retirement plan?

Transferring only after-tax amounts from your retirement plan to a Roth IRA is not allowed. You must rollover your 401(k) contributions in direct proportion to what you already have in the fund. If your account was funded by 90% in pre-tax dollars and 10% after-tax 401(k) contributions, any transfers must be composed of the same fund percentage.

What are the benefits of after-tax 401(k) contributions?

The benefits of after-tax 401(k) contributions include direct paycheck deductions, tax-deferred earnings, an increased maximum contribution limit, flexible withdrawal, plan portability, rollover options, and no income limits.

What are the drawbacks of after-tax 401k contributions?

The drawbacks of after-tax 401(k) contributions are limited investment options, a complex rollover process, and taxable earnings.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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