What Is an After-Tax Contribution?
An after-tax contribution is money paid into a retirement or investment account after income taxes on those earnings have already been deducted. When opening a tax-advantaged retirement account, an individual may choose to defer the income taxes owed until after retiring, if it is a traditional retirement account, or pay the income taxes in the year in which the payment is made, if it is a Roth retirement account.
Some savers, mostly those with higher incomes, may contribute after-tax income to a traditional account in addition to the maximum allowable pre-tax amount. They don't get any immediate tax benefit. This commingling of pre-tax and post-tax money takes some careful accounting for tax purposes.
Key Takeaways
- After-tax contributions can be made to a Roth account.
- Typically funding a 401(k) is done with pre-tax dollars out of your paycheck.
- If you think you will have a higher income after retirement, contributing to a Roth may make sense.
- The 2023 annual limit on funding an IRA is $6,500 per year if under 50 years of age ($7,500 for those aged 50 and over). For 2024, these numbers are $7,000 and $8,000, respectively.
- There is an income threshold for being eligible to contribute to a Roth IRA account.
Understanding After-Tax Contributions
In order to encourage Americans to save toward their retirement years, the government offers several tax-advantaged retirement plans such as the 401(k) plan, offered by many companies to their employees, and the IRA, which anyone with earned income can open through a bank or a brokerage.
Most, but not all, people who open a retirement account can choose either of the two main options:
- The traditional retirement account allows its owner to put "pre-tax" money in an investment account. That is, the money is not subject to income tax in the year it is paid in. The saver's gross taxable income for that year is reduced by the amount of the contribution. The IRS will get its due when the account holder withdraws the money, presumably after retiring.
- The Roth account is the "after-tax" option. It allows the saver to pay in money after it is taxed. That is more of a hit to the person's immediate take-home income. But after retirement, no further taxes are owed on the entire balance in the account. The Roth 401(k) option (referred to as a designated Roth option) is newer, and not all companies offer them to their employees. Earners above a set limit are not eligible to contribute to a Roth IRA account.
Post-Tax or Pre-Tax?
The post-tax Roth option offers the attraction of a retirement nest egg that is not subject to further taxes. It makes the most sense for those who believe they may be paying a higher tax rate in the future, either because of their expected retirement income or because they think taxes will go up.
In addition, money contributed post-tax can be withdrawn at any time without a fat IRS penalty being imposed. (The profits in the account are untouchable until the account holder is 59½.)
On the downside, the post-tax option means a smaller paycheck with every contribution into the account. The pre-tax or traditional option reduces the saver's taxes owed for the year the contributions are made, and it is a smaller hit to current income.
The downside is, that withdrawals from this type of retirement fund will be taxable income, whether it's money that was paid in or profits from the money earned.
After-Tax Contributions and Roth IRAs
A Roth IRA, by definition, is a retirement account in which the earnings grow tax-free as long as the money is held in the Roth IRA for at least five years. Contributions to a Roth are made with after-tax dollars, and as a result, they are not tax-deductible. However, you can withdraw the contributions in retirement tax-free.
Both post-tax and pre-tax retirement accounts have limits on how much can be contributed each year:
- The annual contribution limit for both Roth and traditional IRAs is $6,500 for tax year 2023 (increasing to $7,000 in 2024). Those aged 50 and over can deposit an additional catch-up contribution of $1,000 in both 2023 and 2024.
- The contribution limit for Roth and traditional 401(k) plans is $22,500 for 2023 (increasing to $23,000 in 2024), plus $7,500 for those age 50 and above in both 2023 and 2024.
If you have a pre-tax or traditional account, you will have to pay taxes on money withdrawn before age 59½, and the funds are subject to a hefty early withdrawal penalty.
Early Withdrawal Tax Penalty
As noted, the money deposited in a post-tax or Roth account, but not any profits it earns, can be withdrawn at any time without penalty. The taxes have already been paid, and the IRS doesn't care.
But if it's a pre-tax or traditional account, any money withdrawn before age 59½ is fully taxable and subject to a hefty early withdrawal penalty.
An account holder who changes jobs can roll over the money into a similar account available at the new job without paying any taxes. The term "rollover" is meaningful. It means that the money goes straight from account to account and never gets paid into your hands. Otherwise, it can count as taxable income for that year.
Special Considerations
As noted above, there are limits to the amount of money that a saver can contribute each year to a retirement account. (Actually, you can have more than one account, or a post-tax and a pre-tax account, but the total contribution limits are the same.)
Withdrawals of after-tax contributions to a traditional IRA should not be taxed. However, the only way to make sure this does not happen is to file IRS Form 8606. Form 8606 must be filed for every year you make after-tax (non-deductible) contributions to a traditional IRA and for every subsequent year until you have used up all of your after-tax balance.
Since the funds in the account are separated into taxable and non-taxable components, figuring the tax due on the required distributions is more complicated than if the account holder had made only pre-tax contributions.
What Are the IRA Limits?
The IRA contribution limits for 2023 are $6,500 ($7,000 in 2024). If you are aged 50 and over, you may contribute an additional $1,000 in both 2023 and 2024. These limits are for both traditional IRAs and Roth IRAs.
Can I Contribute to Both a Traditional IRA and a Roth IRA?
Yes, you can contribute to both a traditional IRA and a Roth IRA. There are no restrictions on contributing to both; however, the total amount you contribute to both cannot be over the overall limit for IRAs set by the IRS, which is $6,500 in 2023 and $7,000 in 2024, with an additional $1,000 allowed in both years if you're 50 and over.
Is It Better to Do Pre-Tax or After-Tax Contributions?
Whether it is better to do pre-tax or after-tax contributions will depend on the individual and their financial circ*mstances. Generally, it is recommended that pre-tax contributions are better for higher-earners while after-tax contributions are better for lower-earners, particularly those who expect to be in a higher tax bracket when they retire.
The Bottom Line
After-tax contributions into retirement accounts can be beneficial if you expect to be in a higher income-tax bracket when you are retired. This may not always be the case and everyone's situation is difficult. Generally, it's good to have a mix of retirement accounts that allow for tax advantages in the present and when you are retired.
