after-tax contributions to 401K - pros/cons?

[simple girl]

Hello!

DH and I (ages 42, 38) have the ability to contribute extra $$ to his 401K with AFTER-TAX $$ (we max out our pre-tax contributions and fully fund both of our Roth's). We are thinking, though, that it might be better to put this extra $$ in our regular taxable account...

Pro's of putting after-tax into 401K are that it will grow tax-free. However, when we take it out, we believe that it will be taxed as ordinary income. We also aren't sure, but believe that our ability to take the $$ out early for FIRE may be hindered (still need to find out the details on this/penalties/etc.).

Putting it into our taxable account means it won't grow tax-free (but we'd put it in a tax-managed account to minimize taxes while it is accumulating). However, when we withdraw funds, it should all be taxed at the lower capital gains tax-rate vs. ordinary income tax rate. Also, we can withdraw the $$$ without any restrictions, which is a big bonus, given we want to FIRE as early as possible.

So, I guess the question is: do the savings achieved via the 401K tax-deferred growth outweigh (1) the savings of being taxed at a lower rate upon withdrawal and (2) the ability to access our $$ easily for FIRE? We think putting the $$ into taxable accounts is the better strategy, but would really like to hear other's thoughts on this.

Thanks,
simple girl

 

[rs0460a]

when we take it out, we believe that it will be taxed as ordinary income.

Only the gains will be taxed, not the original amount of the after tax contribution. I have used this vehicle for accumulation in the past, and still do so. In the past, since our company was "bought out" and the existing 401K plan was "replaced" by their 401K, I had two after tax "pots". One with after tax $$$ from the original company, and the existing "pot" based upon the surviving organization. While both "pots" (e.g. buckets?) co-existed, I "cashed one in" to buy a car, purchase a ring for my DW, and other "non-useful acts". I only received a tax statement on the gains the after tax money made, while sitting in the 401k.

The remaining "pot" will be "retired" (as I will be, next May). That money will be used to provide me with after-tax income (almost a year's worth) with a tax bill on only the gains that it has made (and one of the reasons that will help me ER).

Does it make sense – is there a great advantage? When you think about it, not really. For me it did, since most all my investments are in tax-deferred investment vehicles. In addition, since it was in the form of an automatic payroll deduction, there was no need to even think about it. Yes, I know that auto-investment to taxable funds can be made automatic from a bank account, but I didn't even see it, since it came directly out of my paycheck. I was "comfortable" with the 401K investment scheme. This was just a continuation of that scheme.

Either way to handle after tax investments is not the point; the point is that you continue to save/invest in a manner that makes sense to you, and will allow you to continue to save/invest and prepare for your future.

- Ron

 

[gindie]

With deductible and non-deductible IRA's (an similar situation of your before-tax and after-tax 401Ks) every withdrawal will be considered as coming from each of the two pots, in the same proportion as your original contributions. If this is the same with 401K's (and I don't know if it is), then your recordkeeping will be a bit more complex.

 

[rs0460a]

your recordkeeping will be a bit more complex.

Fortunately, the 401K provider (in this case, Fidelity) shows (on-line, daily) the amount of total after tax contribution, the related total gains (hopefully!) and the total estimated tax (based upon your input on rates) due. The tax is deducted from the net amount that is direct-deposited to your specified savings/checking account (very easy, very smooth!)

- Ron

 

[LOL!]

Pros: None that I can think of.

Con: Your gains are taxed at ordinary income tax rates instead of at the lower long-term capital gains tax rate if you had put the money in an after-tax account.
Con: You pay a penalty for early withdrawal in contrast to no penalty if you had just put the money in an after-tax account.
Con: You limit the allowed investments to those offered by the 401(k) plan ... they are probably high expense ratio in contrast to low expense ratio investments available from Vanguard et al outside the 401(k) plan.


Edit: There are plenty of investments which by their nature are tax advantaged without being named tax-managed or tax-advantaged. For example, just buy an ETF and don't trade or sell it. It might have a minor amount of dividends, but you won't pay any taxes on unrealized capital gains.

Edit: Con: You cannot easily deduct any capital losses which of course are easily deductible in an after tax account.

 

[jazz4cash]

I had this situation with my 401k which is managed by Fidelity. There was NO EARLY WITHDRAWAL PENALTY for the after-tax contributions, but this fact was not written anywhere (that I could find) in the plan documents. The problem I had was that the funds were "intermingled". Even tho the account summary webpage shows a total for each source (i.e. pre-tax, after-tax, etc), you could not withdraw the pretax without also withdrawing the after-tax. There is a formula that dictates a pro-rata withdrawal of pre-tax and after-tax. My 401k permits rollovers, so it was easy to get around the problem by rolling the pre-tax portion to a Fidelity IRA and they sent me a check for the after-tax portion. I did a few times until I recovered the entire after-tax contribution. Overall, it's probably best not to intermingle the contributions in the first place.

 

[dmpi]

PRO: In the future you may be able to convert a 401K to a Roth 401K.
Might be best to get as many dollars in there as you can.

PRO: If you think you'll be in the same tax bracket when your pulling out money
then I would pay my tax now vs. later. I expect to see higher tax rates in the future.

CON: You are stuck with the investment choices that your 401K provides.

 

[heyyou]

AFTER-TAX contribution means just that. You do not owe tax when you withdraw that contribution. You can withdraw it at any time without penalty. The earnings from the after-tax are mixed with the earnings from your regular 401k contributions. Your after-tax earnings, your regular 401k contributions, and their earnings are all taxed upon withdrawal.
I liked my after-tax contributions: easy to start, no hassle passive investing, I hid my rising income from my checking account, no need for an after-tax account, and the earnings did not add to current income. At retirement, those after-tax contributions can be withdrawn as cash or rolled over into an IRA with the rest of the 401k. If rolled over, at withdrawal, you will owe tax on only a fraction (a large fraction like 95%) of each withdrawal, since some of each withdrawal (maybe 5%) will be after-tax contributions being returned to you.
You are wise to max your 401k, IRAs, and still have $ left for after-tax. At ER, our lifestyle costs were low since we had saved income like you two, so we needed a smaller nest egg to retire, so we retired early since we had enough saved.

 

[LOL!]

PRO: If you think you'll be in the same tax bracket when your pulling out money
then I would pay my tax now vs. later. I expect to see higher tax rates in the future.

Please explain the above with respect to after-tax contributions. You pay tax now on the after-tax contributions anyways. And you pay a higher tax rate later when you pull gains out than if you had just invested outside the 401(k).

....
Your after-tax earnings, your regular 401k contributions, and their earnings are all taxed upon withdrawal.
....
I liked my after-tax contributions: easy to start, no hassle passive investing, I hid my rising income from my checking account, no need for an after-tax account, and the earnings did not add to current income. At retirement, those after-tax contributions can be withdrawn as cash or rolled over into an IRA with the rest of the 401k. If rolled over, at withdrawal, you will owe tax on only a fraction (a large fraction like 95%) of each withdrawal, since some of each withdrawal (maybe 5%) will be after-tax contributions being returned to you.

One can set up automatic passive investing for an after-tax account as well. It's easy to start, no hassle passive investing. You can hide your rising income from your checking account, and save on your taxes in retirement, and the unrealized capital gains do not add to current income. At retirement, those after-tax accounts canbe withdrawn as cash, you will owe tax on only a fraction of each withdrawal and it will be taxed at the MUCH lower long term capital gains tax rate.


Does everyone understand that their marginal income tax rate is higher than their long term capital gains tax rate? Does everyone understand that unrealized capital gains are not taxed?

 

[dmpi]

Please explain the above with respect to after-tax contributions. You pay tax now on the after-tax contributions anyways. And you pay a higher tax rate later when you pull gains out than if you had just invested outside the 401(k).

I was comparing pre-tax 401K vs. after-tax 401K. I would rather pay the tax now at the lower rate than later at a higer rate.

 

[d]

if one has a large percentage of one's portfolio in tax deferred accounts, it makes some sense simply from a diversification point of view to balance that ... diversifying the future tax risk. (as mentioned previously, the possible accounting nightmare itself would lead me to avoid the after-tax contribution.)

 

[FinanceDude]

I have never done it myself, and would not advise clients to do it unless they have NO self-discipline for investing outside of the 401k..........

Same problems as ALL 401K's............limited choices, and for the most part YOU have no control when the top brass changes to a crappy provider.........

 

[simple girl]

PRO: In the future you may be able to convert a 401K to a Roth 401K.
Might be best to get as many dollars in there as you can.

With a Roth401K can you make after-tax contributions and withdraw all $, including growth, tax-free like a RothIRA? If so, is there pending legislation to allow this conversion down the road

Otherwise, we are coming to the conclusion that the advantage of money growing tax-free doesn't outweigh the other advantages of a regular taxable account - lower expense ratios, larger choice/control, and the biggest point - being taxed at capital gains rate, not ordinary income rate.

Thanks to all for the excellent feedback. this group is great!

simple girl

 

[dmpi]

With a Roth401K can you make after-tax contributions and withdraw all $, including growth, tax-free like a RothIRA? If so, is there pending legislation to allow this conversion down the road

Actually I think I am wrong about this. You cannot convert a 401K to a Roth401K, but rather you can convert a 401K to a IRA and then the IRA to a Roth IRA. So this really boils down to paying the tax now vs. when you do the IRA to Roth IRA conversion. And will you have enough money outside the IRA to pay the tax bill to do the conversion.

 

[nun]

Hello!

DH and I (ages 42, 38) have the ability to contribute extra $$ to his 401K with AFTER-TAX $$ (we max out our pre-tax contributions and fully fund both of our Roth's). We are thinking, though, that it might be better to put this extra $$ in our regular taxable account...

Pro's of putting after-tax into 401K are that it will grow tax-free. However, when we take it out, we believe that it will be taxed as ordinary income. We also aren't sure, but believe that our ability to take the $$ out early for FIRE may be hindered (still need to find out the details on this/penalties/etc.).

Putting it into our taxable account means it won't grow tax-free (but we'd put it in a tax-managed account to minimize taxes while it is accumulating). However, when we withdraw funds, it should all be taxed at the lower capital gains tax-rate vs. ordinary income tax rate. Also, we can withdraw the $$$ without any restrictions, which is a big bonus, given we want to FIRE as early as possible.

So, I guess the question is: do the savings achieved via the 401K tax-deferred growth outweigh (1) the savings of being taxed at a lower rate upon withdrawal and (2) the ability to access our $$ easily for FIRE? We think putting the $$ into taxable accounts is the better strategy, but would really like to hear other's thoughts on this.

Thanks,
simple girl

Putting after tax contributions into a 401k makes for a complicated tax situation and tracking is a bit of a pain particularly if you roll it over into an IRA. In fact if you do that its a good idea to take the after tax contribution out (which you can do without tax consequences), then you can put the money into a ROTH if your income allows you to qualify. In fact a ROTH is a better place to put those extra after tax retirement dollars.

Saving in tax advantaged retirement accounts MUST be done, but you should also save outside in taxed accounts as this gives you cash/investments that have no restictions on them and give you the fredom to ER.

My strategy is to max out my 403b and then save as much as I can into a regular mutual fund account. I could put more into tax defered accounts, like a 459 or an IRA, but I don't as I feel I'm putting enough into the 403b and I want the freedom of having savings/investments immediately available for ER in an afetr tax account. I know I could do "substantially equal payments" from the 401k when I ER, but I'd rather have the freedom aof a regular account even if I don't get tax free accumulations on it