The Time Is Right for Aftertax 401(k) Contributions
In-plan conversions are a no-brainer for heavy savers who have access to them.
A version of this article previously appeared on June 11, 2021.
For higher-income investors, the "backdoor Roth IRA" maneuver has become an annual ritual—a way to get money into a Roth IRA account even if they earn too much to make a direct Roth IRA contribution.
But high-income, heavy-saving investors should also take a look at aftertax 401(k) contributions, which, when rolled into an IRA, become what is sometimes called a "mega-backdoor Roth." Much like the basic backdoor Roth IRA, this strategy involves aftertax contributions—in this case, to a 401(k)—and then converting them to Roth at some later date.
One of the key benefits of aftertax 401(k) contributions is that they are allowable on top of the basic traditional or Roth contributions, making them ideal for heavy savers looking for additional opportunities for tax-advantaged savings. While aftertax contributions aren't available to everyone with a 401(k), plans that do offer them are increasingly adding features that make it easy to convert those contributions to Roth without leaving the plan.
Factoring in the tax benefits, aftertax 401(k) contributions beat what is usually the only other alternative for heavy savers who have maxed out their retirement accounts: investing in a taxable brokerage account.
While roughly three fourths of 401(k) plans now allow Roth 401(k) contributions, aftertax 401(k) contributions are less common. According to Vanguard's 2022 "How America Saves" report, just 21% of Vanguard plans offered aftertax contributions in 2021, and that figure had increased only slightly over the preceding five years. As with many 401(k) creature comforts, aftertax contributions are mainly available through the plans of larger employers.
One common point of confusion is how aftertax contributions differ from Roth contributions. After all, investors contribute aftertax dollars to Roth accounts, too. But there are a few key differences, one related to contribution limits and the other to tax treatment.
First, the contribution limits: While investors can contribute $20,500 ($27,000 if they're over age 50) to a Roth or traditional/pretax 401(k) account, aftertax 401(k) contributions are even more generous. There's no specific dollar amount for aftertax 401(k) contributions, but total 401(k) contributions, including traditional/Roth contributions, employer contributions, forfeitures, and aftertax contributions, can go as high as $61,000 in 2022 ($67,500 for people 50-plus). For example, let's say a 45-year-old contributed $20,500 and received an additional $10,250 in matching funds from his employer. In that instance, he could contribute an additional $30,250 to the aftertax 401(k) before hitting the $61,000 ceiling for total 401(k) contributions.
But despite the generous contribution limits on aftertax 401(k)s, it's important to understand that there's no reason to make aftertax contributions before maxing out Roth contributions first (or traditional pretax contributions, for that matter).
Why is the Roth 401(k) better? The saver contributes aftertax dollars to both accounts. But while Roth contributions enjoy tax-free compounding beginning on day 1, aftertax 401(k) contributions compound on a tax-deferred basis. (Tax-deferred means that at least part of the assets will be taxable upon withdrawal, whereas tax-free is just what it sounds like.) Only when the employee retires, leaves the company, or the plan allows for what's called an "in-plan conversion," can the employee convert the aftertax contributions to a Roth account. Any investment earnings that have built up in the account can be rolled over to a traditional tax-deferred IRA, where those assets will be taxed upon withdrawal. In essence, the aftertax 401(k) maneuver allows contributors to amass tax-deferred assets, and the contributions to the account can become Roth assets at some later date. But the tax savings aren't as great with an aftertax 401(k) as they are with Roth or traditional 401(k)s.
What's interesting, though, is that many plans that offer aftertax 401(k)s also offer in-plan conversions, which reduces the extent to which assets might rack up gains that are subject to taxation upon conversion. Better yet, some plans have begun offering automatic conversions. That means the participant doesn't have to manually execute the conversions; rather, he or she can elect to have aftertax dollars convert automatically. That greatly reduces what had been one of the key "pain points" of aftertax contributions.
For high-income savers who have access to aftertax 401(k) contributions, fully funding the 401(k) up to the $61,000/$67,500 limit will tend to beat saving in a taxable account, especially if the investor has a good-quality plan and doesn't need the liquidity of the taxable account. That's because the tax drag on the aftertax 401(k) account is much less, particularly if in-plan conversions are available.
To illustrate, let's assume a 42-year-old is maxing out all of the tax-sheltered options she can get her hands on, but she still has another $10,000 per year in aftertax dollars available to invest for the next 25 years prior to retirement. She earns a 5% annualized return on her money over the 25-year period.
If she invested in a taxable account, we'd have to shave her annualized return, at least a bit, to account for the fact that she's subject to dividend and capital gains taxes during her accumulation period. Assuming a modest tax-cost ratio 0.5%, that takes her annualized return down to 4.5%. At the end of the 25-year period, her brokerage account would have grown to $454,592. If she were to begin withdrawing the money after 25 years, she'd owe capital gains taxes on the $204,592 of the account that represents investment appreciation. (She won't be taxed on her $250,000 in contributions again, because she made them with aftertax money.) Assuming a 15% capital gains tax rate (and it would actually be a bit lower because she has paid some taxes already), she'd have an aftertax balance of $423,903 available after 25 years.
If she invested that same $10,000 in an aftertax 401(k) for 25 years and executed regular conversions (better yet, automatic ones), she'd earn the full 5% on her money over that time frame. And unlike the taxable account, she won't have to pay taxes on her money as it grows. (Dividends and capital gains distributions aren't taxed on a year-by-year basis as long as the money stays inside the tax-deferred account.) She'd have $487,920 in the account after 25 years. And assuming she has conducted regular conversions, those funds would be entirely tax-free—almost $65,000 more than if she had stuck with the taxable brokerage account.
Those tax savings would be magnified at higher contribution levels, higher rates of return, over longer time frames, or for investors who are in a higher capital gains bracket than 15%.
As attractive as aftertax 401(k) contributions are from a tax standpoint, they're not the right answer in every situation. As mentioned earlier, investors who need access to their funds without any strictures will be better off investing in a taxable brokerage account. And 401(k) plans that allow for aftertax contributions but don't include an in-plan conversion feature will also be less attractive, in that the aftertax assets can't be rolled into a Roth account until the participant has retired or separated from service.
The quality of the 401(k) plan is another important variable. While aftertax contributions are generally the domain of larger employers, which often field solid investment lineups and feature low fees, offering an aftertax option is no guarantee of plan quality. Thus, if a 401(k) plan isn't great, that can reduce the tax-saving benefits relative to investing in tax-efficient, low-cost investments inside of a taxable brokerage account.