By Ian Berger, JD
With the popularity of Roth 401(k) contributions, after-tax employee contributions have gotten short shrift. But, if your plan offers them, after-tax contributions are worth considering because they can significantly boost your retirement savings.
What are they? After-tax contributions are elective deferrals made from already-taxed salary. You make after-tax contributions to your plan the same way you make pre-tax or Roth contributions (if offered). Unlike earnings on Roth 401(k) contributions, earnings on after-tax contributions are always taxable.
Must plans allow them? 401(k) and 403(b) plans are allowed to offer after-tax contributions. But they are not required to do so, and many do not. 457(b) plans for governmental employees are not allowed to offer them.
Why wouldn’t a 401(k) plan offer them? 401(k) plans are subject to nondiscrimation rules which may limit the amount of after-tax contributions that a high-paid employee can make, based on the amount that low-paid employees make. Since high-paid employees are the ones most likely interested in making after-tax contributions, the nondiscrimination test is often difficult to pass.
What are the dollar limits? There are limits on the amount of elective deferrals (pre-tax and Roth contributions) that a participant can make in a calendar year (for 2020, $19,500; or $26,000 if age 50 or older). After-tax contributions do not count against this limit. However, those contributions, along with all elective deferrals and employer contributions (such as matches), do count against a much higher annual limit – for 2020, $57,000 (or $63,500 for over-age-50 employees who defer the additional $6,500). So, an employee who has maxed out on elective deferrals likely will still have enough room to make substantial after-tax contributions.
Example: Roseanna, age 52, participates in a 401(k) plan that allows after-tax contributions. For 2020, she elects to make pre-tax elective deferrals up to the $26,000 limit. Her employer’s matching contribution is $5,000. If she can afford it, Roseanna could make up to $32,000 [$63,000 – ($26,000 + $5,000)] in after-tax contributions.
The mega backdoor Roth. The ability to make large after-tax contributions has led some advisors to promote the “mega backdoor Roth” as a way of converting those contributions to Roth IRAs. However, because of nondiscrimation testing, the mega backdoor Roth strategy usually will not work. See more details at: https://www.irahelp.com/slottreport/mega-backdoor-roth-usually-too-good-be-true.
When are distributions allowed? Plans that offer after-tax contributions are permitted (but not required) to allow in-service withdrawals before age 59 ½. By contrast, pre-tax deferrals generally may not be withdrawn in-service before age 59 ½ — except in the case of hardship withdrawals (if offered).