Should You Make Aftertax Contributions to Your 401(k)?

Heavy savers may have cheered the new, higher 401(k) contribution limits that went into effect for 2015: $18,000 for investors under age 50 and $24,000 for those 50-plus.

What they may have not been paying attention to, however, is that some 401(k) plans allow additional aftertax 401(k) contributions, up to the IRS limit of $53,000 for all 401(k) contributions in 2015. The ability to make those aftertax contributions (not to be confused with Roth 401(k) contributions) isn't new, but new IRS regulations on how those aftertax monies are handled when they're rolled over into an IRA make such contributions more attractive than they were before.

Assuming the plan allows aftertax contributions and the investor follows the correct steps when converting them to a Roth IRA, the aftertax contributions become, effectively, Roth IRA contributions after conversion. That gives heavy savers more access to Roth contributions than would be the case if they relied strictly on direct Roth 401(k) and IRA contributions.

That said, aftertax 401(k) contributions will tend to only make sense for certain investors, and even they will want to take advantage of other tax-sheltered vehicles before funding their 401(k)s with aftertax dollars.

3 Choices for 401(k) Contributions To review, investors can make three types of 401(k) contributions, provided their plans allow for them, each of which carries its own tax treatment.

The first, and by far the most common, is a pretax 401(k) contribution; the money compounds on a tax-deferred basis and the whole kitty is ultimately taxed upon withdrawal.

In addition, some plans also allow for Roth contributions, meaning that the investor contributes money that has already been taxed but enjoys tax-free compounding; withdrawals of contributions plus investment earnings are tax-free in retirement.

Finally, some 401(k) plans allow contributions of additional aftertax monies for investors who want to set additional assets aside for retirement, above and beyond what they're making in pretax or Roth contributions. The key benefit of such contributions--until recently, that is--is that retirees can enjoy tax-deferred compounding on those aftertax contributions; investment earnings are taxed as ordinary income when withdrawn.

However, the new IRS regulations make aftertax contributions more attractive from a few angles. In addition to the tax-deferred compounding that such assets enjoy, the new IRS regulations allow the retiree to effectively segregate the aftertax assets from the pretax monies at the time of rollover into an IRA. Pretax 401(k) assets--both pretax contributions and all investment earnings--can be rolled into a Traditional IRA, whereas the aftertax dollars can be converted into a Roth IRA.

That represents a change from the recent past, when investors had to engage in a series of complicated maneuvers to segregate their aftertax dollars from their pretax 401(k) monies in an effort to get them into a Roth IRA. Michael Kitces, a partner and director of research for Pinnacle Advisory Group and publisher of the financial-planning industry blog Nerd's Eye View details the old rules, as well as what has changed, here.

Although the latest IRA ruling simplifies things quite a bit, investors may be confused about how this maneuver is different from investing in a Roth 401(k), and where--if at all--aftertax 401(k) contributions should fall in the tax-sheltered funding queue.

Here are some common questions, along with answers, about aftertax 401(k) contributions.

Q: Is making an aftertax 401(k) contribution the same as making a Roth 401(k) contribution? Both involve aftertax dollars.

A: No. The two differ in a few key ways. First, Roth 401(k) contributions are subject to the usual 401(k) contribution limits--in 2015, that's $18,000 and $24,000. Aftertax 401(k) contributions can be higher, as long as the total 401(k) contribution doesn't exceed $53,000.

More importantly, the tax treatment of Roth 401(k) contributions and aftertax contributions is different. The earnings on Roth 401(k) contributions begin compounding tax-free from the get-go. Meanwhile, to the extent that the aftertax contributions generate investment earnings inside the 401(k), those earnings compound on a tax-deferred--not tax-free--basis.

Only when the aftertax dollars are removed from the 401(k) and converted to a Roth IRA--which the new regulations allow investors to do, provided they have retired, left the company, or can take in-service distributions from their plans--can they begin earning tax-free interest. The pretax component of the 401(k)--consisting of pretax contributions plus any investment earnings that accrued while those assets were inside of a 401(k)--can only be rolled into a Traditional IRA. If the investor wanted to convert any of those assets to Roth, taxes would be due. To the extent that those assets stay inside of a Traditional IRA, they will be taxed at the investor's ordinary income tax rate upon withdrawal.

Because the aftertax 401(k) contributions don't begin tax-free compounding until they've been rolled into an IRA, Kitces notes they're less desirable than making direct Roth 401(k) or IRA contributions. "You can literally think of the aftertax 401(k) conversion strategy as a 'deferred Roth contribution strategy,'" he said. "Deferred Roth is better than no Roth, but Roth now is still better than Roth deferred."

Because investors gain more tax-saving features by making pretax or Roth contributions to their 401(k)s and IRAs, Kitces says heavy savers should exhaust those options before turning to aftertax 401(k) contributions. He outlines a hierarchy of tax-advantaged savings options in this post.

Q: So, why would anyone want to make aftertax 401(k) contributions?

A: Tax-deferred compounding has always been a benefit to making aftertax IRA contributions. Under the new regulations, however, investors can effectively steer more assets into the Roth column than they otherwise could by converting their aftertax 401(k) contributions into a Roth IRA. Once the rollover is complete, all of those assets can begin compounding on a tax-free basis, and withdrawals will be tax-free. Importantly, Roth IRA assets aren't subject to required minimum distributions, either.

By making aftertax contributions that are eventually converted to Roth IRA assets, investors can build a higher level of Roth assets than is allowed with direct Roth IRA and 401(k) contributions.

Q: Given this opportunity, is there any advantage to continuing to invest in a taxable account, or should I try to make the maximum contribution to all of my tax-sheltered options--including aftertax 401(k) contributions--before saving in my taxable account?

A: Liquidity--the ability to remove assets without strictures or penalties when you need it--is one key reason to invest in a taxable brokerage account versus saving in any sort of tax-sheltered wrapper. But David Blanchett, Morningstar Investment Management's head of retirement research, thinks that high-income savers have good reason to make aftertax contributions once they've met their liquidity needs within their taxable accounts. "I think it would make sense for higher-income folks to max out the 401(k) with aftertax monies," he said. "In theory, the only reason you wouldn't do that versus, say, saving the monies in a taxable account is if you needed the money before retirement."

Q: Are there any big drawbacks to making aftertax 401(k) contributions?

A: It's not a drawback, per se, but not every plan allows for aftertax contributions, so that's the first hurdle. Kitces also notes that things can get complicated for investors who don't roll over their entire 401(k) balances, as outlined here.

Blanchett is also concerned that the new IRS guidelines could face legislative risk, because they effectively allow high-income earners to compile even more tax-advantaged assets for retirement. He notes that, in contrast to the recently proposed (and quickly scuttled) changes in 529 tax treatment, "aftertax 401(k) monies have already been taxed, so it would seem far easier to just force people that have made this type of contribution to pay taxes when they eventually take out the monies."

Kitces believes the quality of the 401(k) plays a role. "Aside from the 401(k) having unusually high costs or especially bad investment choices (so you just don't want to put money in), or amazing investment choices (such that you don't want to roll money out even if you can), there's not much to contraindicate the strategy."