Aftertax 401(k): Most Investors Should Walk on By

Note: This article is part of Morningstar's Tax Relief Week special report.

I've recently heard a surprising number of questions about aftertax 401(k) contributions--surprising because I generally think of aftertax 401(k) contributions as appropriate for a small subset of the population.

The reason for the uptick in interest is because the option to make this type of contribution has been added to more and more plans following a change in IRS regulations in 2015. (Financial planning guru Michael Kitces does a deeper dive into the regulations that make aftertax 401(k) contributions more attractive in this post.)

In every case, asking a simple question clears up whether an aftertax 401(k) makes sense: Are you maxing out the 401(k) already? If you're not putting the full $18,000 (or $24,000 for those 50-plus) into a 401(k), you don't have any reason to make aftertax contributions to the plan. Because their tax benefits are more limited, aftertax contributions will always come up short relative to pretax and Roth contributions.

Aftertax Contributions Unpacked To review, there are three major types of 401(k) contributions that employees can make: pretax, Roth, and aftertax. Pretax and Roth are subject to the annual limits of $18,000 (under age 50) and $24,000 (over 50). Yet a higher limit of $54,000 applies to all contributions--not just the employee's own pretax or Roth contributions, but employer-matching contributions, allocations of forfeitures (mainly nonvested assets of employees who have left the plan), and aftertax contributions as well.

With pretax 401(k) contributions, by far the most common contribution type, the employee steers a portion of his or her salary into the plan before paying tax on that money. If an employee contributes $18,000, the full $18,000 can start compounding on day 1. The money compounds on a tax-deferred basis, but when the investor begins withdrawing in retirement, the entire withdrawal is taxed at his ordinary income tax rate.

The tax treatment of Roth 401(k)s is exactly the opposite. The employee puts in money that has already been taxed, but withdrawals in retirement are tax-free. For example, if any employee steers 10% of her $180,000 salary into the Roth 401(k) and she's in the 25% tax bracket, her net contribution is $13,500 ($18,000 X 0.75). The money compounds on a tax-free basis, and her big payoff comes when she retires: All of her withdrawals from the Roth 401(k) will be tax-free.

So what's the difference between Roth 401(k) contributions and aftertax contributions? They both involve aftertax money, so this aspect naturally trips people up. But the key difference is that the person who makes Roth 401(k) contributions enjoys tax-free compounding immediately, and withdrawals of the whole balance will be tax-free.

By contrast, the aftertax 401(k) contributor enjoys tax-deferred compounding on his or her dough. When he or she retires, leaves the company, or takes an in-service distribution from the plan (which only a subset of plans allow), only then can those aftertax contributions be shunted over to a Roth IRA, where they can begin growing tax-free. Meanwhile, any investment earnings that have built up on the initial aftertax contribution can be rolled into a traditional IRA when the employee leaves the firm, retires, or takes an in-service distribution; when those never-been-taxed monies are eventually withdrawn, they'll be taxed as ordinary income.

By the Numbers A simple illustration can demonstrate how pretax or Roth contributions will always come out ahead of aftertax contributions, accentuating the point that aftertax contributions are best employed only after an investor has made the maximum contribution to a Roth and/or pretax 401(k).

Example 1: Pretax Contributions Jake makes a 15,000 pretax 401(k) contribution for 35 years. His assets grow 5% per year, amounting to $1,354,805 at the end of the 35-year period. When he begins taking withdrawals in retirement, he's in the 25% tax bracket, bringing his aftertax withdrawals to $1,016,104.

Example 2: Roth Contributions Emily steers $15,000 of her paycheck into the 401(k) for 35 years, just like Jake. But because she has elected Roth contributions, her money is taxed before it goes into her 401(k). Assuming she's in the 25% tax bracket, she's putting $11,250 into the plan per year; if the money grows tax-free and is tax-free upon withdrawals, her total withdrawal amount will also be $1,016,104. (The Emily and Jake examples illustrate that if someone is in the same tax bracket at the time of contribution and retirement, there's no difference between Roth and pretax contributions, as discussed in this article.)

Example 3: Aftertax Contributions Andy directs $15,000 of his paycheck to an aftertax 401(k), so his $15,000 contribution drops to $11,250 per year, just like Emily's. The money then compounds tax-deferred; for consistency's sake, let's say it earns 5% and Jake makes the same $11,250 contribution each year for 35 years. At that time, he'd have $1,016,104 in total. However, only his $393,750 in contributions would be eligible for rollover into a Roth IRA. (That money has already been taxed.) The other $622,354--representing his investment earnings--would need to be rolled over into a traditional IRA, where it would be taxed at his ordinary income tax rate upon withdrawal. Assuming he's in the 25% income-tax bracket at that time, his total aftertax withdrawal from both kitties would be $860,516, well below the aftertax take with the Roth or pretax contributions outlined above.

Why Bother? The logical next question is why anyone would bother with aftertax contributions. And the short answer is that you very likely shouldn't, unless you're already maxing out your baseline contributions of $18,000/$24,000 to the 401(k). The benefit of the aftertax 401(k) comes in only after someone has maxed out those contributions, contributed to an IRA as well (and possibly a health savings account to boot) and still has excess money to invest for retirement.

For such investors, the main benefit comes in when they are able to get those aftertax 401(k) assets out of the plan and rolled over into a Roth IRA, where they can begin compounding tax-free. Notably, Roth assets also skirt required minimum distributions, making aftertax contributions particularly attractive for heavy savers who don't expect to need all or part of their Roth IRAs during their retirements; those assets can be passed on to heirs. For affluent investors who can take an in-service distribution--meaning that they can get their aftertax 401(k) assets into a Roth IRA while they're still working--the aftertax 401(k) is particularly appealing. Ditto for job-hoppers, who will have more opportunities to extract their 401(k) assets well before retirement.