What’s the Difference Between an After-Tax 401(k) vs. Roth 401(k)?
Many employers in the United States offer a 401(k) plan to help employees save for retirement. And when you set up your account, you’ll often have the choice between different types of contributions. In recent years, Roth contributions have become especially popular. While they don’t provide any immediate tax deductions, the after-tax contributions grow and compound tax-free translating to tax-free retirement withdrawals in the future.
In addition to a Traditional 401(k) and Roth 401(k), some providers offer an after-tax 401(k). At first glance, you might think Roth and after-tax 401(k) are the same thing since both have contributions made with after-tax dollars. Though, in reality, there are a few key differences between the two that are important to understand.
When you contribute to a Roth 401(k), your contributions are made after taxes, meaning you can’t deduct them to reduce your taxable income, nor do they come out of your paycheck before taxes. The good news is that if used correctly, once the funds are in your 401(k), you’ll never pay taxes on them again. Your investments grow tax-free while they’re in the account, and you can make tax-free withdrawals during retirement.
Roth contributions are subject to many of the same limitations as traditional 401(k) contributions. For example, workers can contribute up to $20,500 per year, with an additional catch-up contribution of $6,500 allowed for workers ages 50 and older. Of course, your employer can also contribute to your account, for a total contribution limit that’s even higher.
Because of the powerful tax benefits, it’s no surprise the Roth 401(k) has become such a popular tool for today’s workers. After all, after paying taxes at the time you earn the funds, you’ll never pay taxes on your investments again. Because the tax burden falls at the time you make the contribution (unlike traditional 401(k) contributions, where the tax burden happens during retirement), they’re especially popular with workers earlier in their careers and those who expect to be in a higher tax rate during retirement.
After-tax 401(k) contributions are similar to Roth contributions in that they’re made with after-tax dollars, and don’t reduce your taxable income in the year you make them. But unlike with Roth contributions, after-tax contributions aren’t subject to the $20,500 limit.
Unlike traditional and Roth 401(k) contributions, after-tax contributions aren’t considered “deferrals”. As a result, instead of being subject to the $20,500 limit on elective deferrals, they’re subject to the overall limit on contributions, which, in 2022, is $61,000 (or $67,500 with the catch-up contribution).
The tax treatment of after-tax contributions comes with a catch. Unlike with Roth contributions, your withdrawals during retirement aren’t tax-free with an after-tax 401(k). Instead, your investment gains at the time of withdrawal will be taxed as ordinary income. This is more beneficial than a traditional 401(k), where all withdrawals — both contributions and earnings — are taxed as ordinary income.
You might be wondering why someone would choose a 401(k) plan that requires them to pay taxes both when they contribute to and withdraw from their account? If your plan allows, the after-tax option should be considered only after contributing the annual limit to your traditional or Roth 401(k). If you’re able to participate, there’s a provision in the tax law that allows after-tax contributions to be converted to Roth contributions. Since you’ve already paid taxes on the contributions, the conversion would only require that you pay taxes on any earnings you’ve accumulated. As such, it’s advantageous to periodically move after-tax contributions out of the 401(k) plan if allowed, and advisable to engage a tax advisor or CPA to help you navigate this strategy successfully.
Making Sense of It All
Generally the after-tax 401(k) only applies after you’ve elected to defer the annual limit to your traditional or Roth 401(k). In the table below, we’ve identified some of the most important features of both Roth and after-tax 401(k) contributions:
|Roth 401(k)||After-Tax 401(k)|
|Taxes on Contributions||Contributions are made after-tax||Contributions are made after-tax|
|Taxes on Withdrawals||Withdrawals are tax-free||Withdrawals are taxed as ordinary income (earnings only)|
|Rollover||Contributions can be rolled over into a Roth IRA||Contributions can be rolled over into a Roth IRA|
Roth contributions have become increasingly popular among workers, since they allow for tax-free investment growth and tax-free withdrawals during — and even before — retirement. And for most people, Roth 401(k) contributions are a great choice if you expect to be in a lower income bracket in retirement.
But what if you’re a high-earner who wants to save more than $20,500 per year in a tax-advantaged account? In that case, you might be better off deferring the $20,500 to a traditional 401(k) and contributing additional savings to an after-tax 401(k). You still enjoy some of the tax advantages that come with a Roth IRA, but with a potentially considerably higher contribution limit.
In addition to higher earners, other people who may enjoy this after-tax benefit are those with a fluctuating income. It’s possible that during certain years, the amount you can save for retirement is lower. But in other years, you’re able to save more than the $20,500 limit. In that case, you can use after-tax contributions to save more in a tax advantaged vehicle. .
The possible downside of the after-tax 401(k) is the tax treatment of withdrawals during retirement. The good news is some plans allow you to get around that by converting your after-tax funds to Roth funds using an in-plan conversion or a rollover to a Roth IRA.
Ultimately, both Roth and after-tax 401(k) plans can be valuable tools to supplement income, tax-free, in retirement. Your income and the amount you can save each year will be the major determining factor in whether Roth or after-tax contributions are right for you. If you can save $20,500 or less and expect to be in a lower tax bracket in retirement, then the Roth 401(k) is a great option. If you want to and can afford to save more than that, consider the after-tax 401(k).
The Bottom Line
Preparing for retirement is part of your overall financial plan. You can take a few actions now to get yourself on the right track.
- Download 65 Ways to Retire Smart, an actionable guide with insights from fiduciary financial advisors. The guide is free.
- Sign up for the Personal Capital Dashboard. Millions of people use these free and secure professional-grade online financial tools. You can use them to see all of your accounts in one place, analyze your spending, and plan for long-term financial goals.
- Consider talking to a fiduciary financial advisor for more detailed guidance on your retirement saving strategies.