Pros and Cons of After Tax 401K Contributions

[TooFrugal]

My husband's work 401K allows after tax contributions. It isn't a Roth, the contributions are from taxable income and the earnings are tax deferred. I haven't been able to find too much information on the pros and cons of doing this.

I know it is good to max out the pre-tax 401K contributions first, and I know about the nondeductible IRA to Roth IRA loophole for 2010, but after that what do you think of making after tax contributions to a 401K plan?

Any thoughts are appreciated.

 

[harley]

I had after tax money in my 401K when I retired. Not much, about 2% of the total. I think it came from years where my contributions exceeded the allowed pre-tax amounts. As an intentional choice I think it's a mistake. It complicates bookkeeping, especially when the time comes to roll it into an IRA. In my case it was easier to take the after tax amount as a check, to keep from having to keep track of it in the IRA. I'm not sure of the reason but they (Fido) told me I couldn't just roll it into a Roth.

I would strongly recommend going the nondeductible IRA route with any after tax money. The rollover isn't a loophole, and it's not limited to 2010. I find it much easier to keep my pre and post tax dollars seperate.

Edit: Also, you have more control over the investments by directing the after tax money to an IRA vs. the 401K.

 

[kaneohe]

I would strongly recommend going the nondeductible IRA route with any after tax money. The rollover isn't a loophole, and it's not limited to 2010. I find it much easier to keep my pre and post tax dollars seperate.

Edit: Also, you have more control over the investments by directing the after tax money to an IRA vs. the 401K.

Harley.........isn't the issue w/ pretax/after tax 401K very similar to having deductible/non-deductible IRAs. In both cases you have to keep track of the basis.... e.g. you can't just withdraw from the non-deductible IRA and expect to pay no taxes (even if no earnings there) if you had deductible IRAs as well. As you note, there would be more choices w/ the IRA. There might be more creditor protection for the 401K depending on what state you live in.

 

[LOL!]

First the pro:
1. If you need more fixed income in a tax-sheltered space, then the 401(k) is tax-sheltered space. Be sure to max out all IRA and other tax-sheltered space first.

Now the cons:

1. The fees in a 401(k) are usually higher than elsewhere.
2. You cannot deduct losses in your investments from your taxes.
3. Gains are taxed at your higher marginal income tax rate instead of the lower long-term cap gains tax rate and the lower qualified dividend rate.
4. Cannot withdraw trivially without penalty before age 59 1/2.
5. Limited investment choices.
6. Heirs do not get a stepped up basis when you die on the gains, but instead get a tax nightmare figuring out the post-tax pro-rated versus the gains versus the pre-tax. They probably throw up their hands and pay taxes again.

Even a contribution to a non-deductible IRA was a terrible idea until one was allowed to convert to a Roth IRA. Can one convert just the post-tax 401(k) contributions to a Roth IRA? I dunno.

 

[teejayevans]

4. Cannot withdraw trivially without penalty before age 59 1/2.
5. Limited investment choices.
.

#4. If you retire at age 55 or later, you can access your 401K immediately.
#5. Sometimes...some plans are better than others.
TJ

 

[travelover]

...............................Can one convert just the post-tax 401(k) contributions to a Roth IRA? I dunno.

Per this article the answer is yes. I am pursuing this now, though I need to wait until 2010 due to income restrictions.

A Sweet Deal on Roth IRA Conversions - Kiplinger.com

"It's a sweet deal that lets you move money to a Roth IRA with no tax costs," says Ed Slott, a CPA and IRA expert in Rockville Centre, N.Y. "You can't do that from an IRA."
Not all retirement plans allow after-tax contributions. But if yours is among those that do, this is a great way to keep some of your retirement savings growing tax-free without paying the usual price of admission to convert to a Roth IRA. Normally, you must wait to switch jobs or retire before you can move money out of your employer-based retirement account. But some plans permit in-service distributions, allowing you to roll over some or all of your 401(k) money to an IRA once you reach age 59½.

 

[Alan]

Harley.........isn't the issue w/ pretax/after tax 401K very similar to having deductible/non-deductible IRAs. In both cases you have to keep track of the basis.... e.g. you can't just withdraw from the non-deductible IRA and expect to pay no taxes (even if no earnings there) if you had deductible IRAs as well. As you note, there would be more choices w/ the IRA. There might be more creditor protection for the 401K depending on what state you live in.

I think Harley's point is that going the IRA route simplifies things. If you are happy with your 401(k) plan options and expenses and don't mind all the pre-tax and after tax money being co-mingled, plus you have max'ed out your IRA, you decide to pay the taxes on the contributions now rather than later.

For me, I am in a high tax bracket and always max out the IRA's with after tax money, as I have no choice, and also max out 401(k) with pre-tax money.

 

[scrabbler1]

TooFrugal, I had a small amount (about 6%) of after-tax dollars in my old 401(k) when I retired last year. I was able to instruct the 401(k) service provider to carefully separate the principal dollars (i.e. my actual after-tax contributions) from the pre-tax dollars and the earnings on all the contributions when I rolled the proceeds into a traditional IRA. This way, only the pre-tax proceeds got rolled into the IRA. The amount of the after-tax contributions was well displayed in the quarterly statements (and verified in my own records) so there was no doubt about the amount.

I cashed out my company's ESOP when I retired, so I used the after-tax 401(k) dollars to pay some of the taxes on the ESOP. Because most of the ESOP was NUA (Net Unrealized Appreciation) and subject to a top tax rate of 15%, the total tax bill on the entire clean-out of my 401(k)/ESOP (worth just over $500k) was just under 15%.

 

[kaneohe]

I think Harley's point is that going the IRA route simplifies things. .

Alan, I'm not sure why this is true even if you segregate the the deductible and nondeductible IRAs. Eventually the earnings in the nondeductible IRAs make them into a mixed bag anyway so you have to keep records. I will concede that early in the game, before earnings are a significant factor,
segregating the IRAs gives you at least some idea of the proportion of deductible/nondeductible whereas you might not any idea in the 401K.
Still, if you are trying to do things accurately, I don't see a difference in the recordkeeping that is necessary.

 

[TooFrugal]

I would strongly recommend going the nondeductible IRA route with any after tax money.

Yes, I would do that first, but there are limits on how much you can contribute to those. We would only consider the after tax 401K after we had maxed out the pretax 401K and the nondeductible IRA contribution limits.

 

[TooFrugal]

Per this article the answer is yes. I am pursuing this now, though I need to wait until 2010 due to income restrictions.

Intriguing article. Thanks

Thanks for all of the comments pros and cons listed so far.

I'm going to have to think about this. I never knew post tax 401K contributions were even an option until yesterday.

Alan, I'm not sure why this is true even if you segregate the the deductible and nondeductible IRAs. Eventually the earnings in the nondeductible IRAs make them into a mixed bag anyway so you have to keep records. I will concede that early in the game, before earnings are a significant factor,
segregating the IRAs gives you at least some idea of the proportion of deductible/nondeductible whereas you might not any idea in the 401K.

For us I am moving the deductible IRAs into the 401ks, so our only IRAs will be nondeductible. Then those will be converted to Roths in 2010. I think that should help simplify our record keeping.

 

[Alan]

Alan, I'm not sure why this is true even if you segregate the the deductible and nondeductible IRAs. Eventually the earnings in the nondeductible IRAs make them into a mixed bag anyway so you have to keep records. I will concede that early in the game, before earnings are a significant factor,
segregating the IRAs gives you at least some idea of the proportion of deductible/nondeductible whereas you might not any idea in the 401K.
Still, if you are trying to do things accurately, I don't see a difference in the recordkeeping that is necessary.

Very true and it probably depends on the vigilance of the individual. By the time I realized I needed to keep close track of things I was able look at my tax returns where it is very obvious what after tax contributions I'd made and could calculate the basis easy enough. On my 401(k) account I can see the after tax contributions including the after tax matches but it doesn't differentiate between the earnings and the contributions (I should only owe tax on the earnings). However, that sum is only about 1.5% of the total so I'm not bothered.

 

[Alan]

For us I am moving the deductible IRAs into the 401ks, so our only IRAs will be nondeductible. Then those will be converted to Roths in 2010. I think that should help simplify our record keeping.

Sounds like the sort of moves I would make.

 

[TooFrugal]

Even a contribution to a non-deductible IRA was a terrible idea until one was allowed to convert to a Roth IRA. Can one convert just the post-tax 401(k) contributions to a Roth IRA? I dunno.

His plan allows contributions up to 50% of salary, any mix of pre-tax and after-tax. He can withdraw the post tax contributions at any time, even while still employed.

If he could really then put his after tax contributions in a Roth IRA next year that would be a truly amazing tax break.

 

[harley]

Alan, I'm not sure why this is true even if you segregate the the deductible and nondeductible IRAs. Eventually the earnings in the nondeductible IRAs make them into a mixed bag anyway so you have to keep records. I will concede that early in the game, before earnings are a significant factor,
segregating the IRAs gives you at least some idea of the proportion of deductible/nondeductible whereas you might not any idea in the 401K.
Still, if you are trying to do things accurately, I don't see a difference in the recordkeeping that is necessary.

In my case I was considering the record keeping, which is not what I'm best at. I would not keep money in a non deductible IRA for any length of time, just long enough to do the Roth conversion (starting in 2010 if you make too much). The earnings in the non deductible IRA would definitely cause the same record keeping issues in the long run, if you left them there.

 

[TooFrugal]

In my case I was considering the record keeping, which is not what I'm best at. I would not keep money in a non deductible IRA for any length of time, just long enough to do the Roth conversion (starting in 2010 if you make too much). The earnings in the non deductible IRA would definitely cause the same record keeping issues in the long run, if you left them there.

At the end of 2010 all we should have are Roth IRAs and the 401Ks. The regular IRAs will be in the 401Ks and the nondeductible IRAs will be Roth IRAs. So I think long term that should make the record keeping easy.

 

[TooFrugal]

I read the IRS ruling on the 401K to Roth IRA conversions. Thanks travlover for the Kiplinger article link. I'll have to talk to our accountant and pension person, but I think we can do the following:

I think my husband can max out his pretax 401K contributions into our small business 401K. Then theoretically, if we have enough savings, my husband could put up to 50% of his after tax day job income into his work 401K. Then he would withdraw the after tax portion of his work 401K and convert it to a Roth IRA the same year.

He has employer matching so he should probably contribute just enough of his pretax 401K into his day job plan to take full advantage of the employer matching, but then but then the rest should go into the business 401K so he can max out the after tax limit at his day job 401K.

Do you think this could work?

 

[clifp]

I have to say, I don't understand why anyone would be make non deductible contributions to either an IRA or a 401K.

On the con side you get a paperwork hassle, and the distinct possibility of running afoul IRS in the future. You have restriction on accessing the money in the future. Finally, when you do withdraw they will taxed at ordinary income rates which probably going to be higher than capital gain rates.

For all of these problems what do you gain?

AFAIK the only benefit you get is is letting your saving grow tax deferred. If you want tax deferred saving why not get an index fund, Berkshire Hathaway (or similar non-dividend paying stock) or even savings bonds? I am hard pressed to figure out a scenario where non deductible contributions come out better than being smart about asset location. (i.e. having fixed income in your deductible 401K/IRAs and index funds etc outside).

 

[LOL!]

I have to say, I don't understand why anyone would be make non deductible contributions to either an IRA or a 401K.

If you convert the non-deductible contribution to a Roth, then it can make sense. Otherwise, I see it as costing you higher taxes down the road.

Maybe some folks mistakenly think you can not invest tax-deferred for retirement in a taxable account?

 

[harley]

I have to say, I don't understand why anyone would be make non deductible contributions to either an IRA or a 401K.

On the con side you get a paperwork hassle, and the distinct possibility of running afoul IRS in the future. You have restriction on accessing the money in the future. Finally, when you do withdraw they will taxed at ordinary income rates which probably going to be higher than capital gain rates.

For all of these problems what do you gain?

AFAIK the only benefit you get is is letting your saving grow tax deferred. If you want tax deferred saving why not get an index fund, Berkshire Hathaway (or similar non-dividend paying stock) or even savings bonds? I am hard pressed to figure out a scenario where non deductible contributions come out better than being smart about asset location. (i.e. having fixed income in your deductible 401K/IRAs and index funds etc outside).

With one exception I agree with you. That exception is if you make too much to contribute to a Roth. You can contribute to a non deductible IRA, then (starting in 2010) convert the non deductible IRA to a Roth, only paying tax on any gains in the non deductible IRA. Other than that, I'm with you 100%.

 

[harley]

Jinx!

 

[TooFrugal]

I am hard pressed to figure out a scenario where non deductible contributions come out better than being smart about asset location.

With the 401K, the money is in an ERISA protected account. So if you live in a state with poor retirement savings protection laws that is huge plus. ERISA accounts have an anti-alienation feature.

This is a good article on it:
ERISA Anti-Alienation Provisions and Welfare Benefit Plans

Or if you convert the money to a Roth IRA, you give up the asset protection aspect of the after tax 401K contributions, but the earnings are now tax free forever, not just tax deferred.

 

[LOL!]

i think you overstate the benefit of ERISA protection. how many people have needed that or couldn't get needed protection via insurance?

 

[TooFrugal]

i think you overstate the benefit of ERISA protection. how many people have needed that or couldn't get needed protection via insurance?

I don't know how many people have needed it and it may not be something important to everyone or even most people. But personally if I can easily and inexpensively get ironclad protection for my decades of savings, I'm going to take advantage of it.

I found this article of interest -
IRAs Could Be Fair Game in Lawsuits -- latimes.com

 

[kaneohe]

Too Frugal.........I'm w/ you on this one. Hopefully I'm understanding correctly that this protection is robust........pretty much only IRS and spouse can attack and I like to think I have some control over those (tho it may be delusional in the case of the latter ). I like the fact that the protection is pretty plain vanilla........no need to file successfully for bankruptcy and no limits. As you suggest, we're probably a very small minority but I have seen a trend over the years to more discussion about this topic.

Reading that article you referenced was a bit confusing to me. A reader could get the impression that CA had reasonable protection compared to a lot of states. My prior impression (which I will retain unless convinced otherwise) was that CA protection was actually among the worst.