What Are After-Tax Contributions?
After-tax contributions are funds deposited into a retirement or investment account after income taxes on those earnings have already been deducted. Individuals can choose between deferring the income taxes owed until after retirement (using a traditional retirement account) or paying the taxes in the year the payment is made (using a Roth retirement account).
Key Insights
- You can make after-tax contributions to a Roth account.
- Typically funding a 401(k) is done with pre-tax dollars deducted from your paycheck.
- If you anticipate a higher income after retirement, contributing to a Roth may be sensible.
- The 2023 annual limit on funding an IRA is $6,500 for those under 50 ($7,500 for those 50 and over). In 2024, these limits increase to $7,000 and $8,000, respectively.
- There is an income threshold that determines eligibility for contributing to a Roth IRA.
The Benefits of After-Tax Contributions
To encourage retirement savings, the government offers various tax-advantaged plans like 401(k) plans, available through employers, and IRAs that can be opened by anyone with earned income. After-tax contributions can offer strategic financial advantages:
The Attraction of Roth Accounts
- Traditional Retirement Accounts: Enable the depositor to invest ‘pre-tax’ money, reducing taxable income for the year of the contribution.
- Roth Accounts: Use ‘after-tax’ payments, leading to no taxes upon qualified withdrawals in retirement, preserving future retirement income.
Pre-Tax vs. Post-Tax Benefits
Contributors to Roth accounts prefer having a retirement nest egg that grows without future tax considerations. Post-tax dollars in Roth accounts provide the advantage of tax-free growth and withdrawal, especially if you expect a higher tax rate during retirement or an increase in tax rates generally.
Considerations and Special Rules
Both pre-tax and post-tax contributions adhere to annual contribution limits. For 2023, Roth and traditional IRAs are capped at $6,500 ($7,000 for 2024), with an additional $1,000 allowed for those over 50. Contribution limits for 401(k) plans stand at $22,500 for 2023 ($23,000 for 2024), along with an extra $7,500 for participants aged 50 and above.
Penalties and Flexibility in Withdrawals
Early Withdrawals and Penalties
- Money from pre-tax accounts like traditional 401(k)s or IRAs is taxable and subject to penalties if withdrawn before age 59½.
- After-tax contributions in Roth accounts can be withdrawn without penalty, although profits are locked until reaching 59½ years of age.
Tax Reporting Requirements
To ensure after-tax contributions to traditional IRAs aren’t taxed upon withdrawal, IRS Form 8606 must be filed. This complex method calculates the taxable and non-taxable portions accurately.
Frequently Asked Questions
What Are the IRA Limits?
The IRA contribution limits stand at $6,500 in 2023 ($7,000 in 2024), with an extra $1,000 for people aged 50 and above.
Can I Contribute to Both Traditional and Roth IRAs?
Yes, contributions to both types are allowed within the total annual limit set by the IRS: $6,500 for 2023 and $7,000 in 2024, plus the extra allowed for catch-up contributions for those 50 and over.
Which Is Better: Pre-Tax or After-Tax Contributions?
Choosing between pre-tax and after-tax contributions will depend on your financial situation and future income expectations. Generally, higher earners benefit more from pre-tax contributions while lower earners might find future rewards from after-tax contributions.
Conclusion
After-tax contributions to retirement accounts can be advantageous, particularly if you anticipate being in a higher tax bracket upon retirement. Diverse retirement accounts such as Roth and traditional IRAs arguably offer the best hedged approach, providing both current and future tax advantages.
Related Terms: Roth IRA, Traditional IRA, 401(k), Rollover IRA, Catch-up Contribution.
References
- Internal Revenue Service. “Rollovers of After-Tax Contributions in Retirement Plans”.
- Internal Revenue Service. “401(k) Plan Overview”.
- Internal Revenue Service. “401(k) Limit Increases to $23,000 for 2024, IRA Limit Rises to $7,000”.
- Internal Revenue Service. “Retirement Plans”.
- Internal Revenue Service. “Publication 590-B (2020), Distributions From Individual Retirement Arrangements”.
- Internal Revenue Service. “Roth IRAs”.
- Internal Revenue Service. “IRS Announces 401(k) Limit Increases to $20,500”.
- Internal Revenue Service. “IRA FAQs - Distributions (Withdrawals)”.
- Internal Revenue Service. “Rollovers of Retirement Plan and IRA Distributions”.
- Internal Revenue Service. “Retirement Topics - IRA Contribution Limits”.
- Internal Revenue Service. “About Form 8606, Nondeductible IRAs”.
