Diversify Tax Exposure in Retirement
After-tax and Roth 401(k) contributions are two different types of contributions to an employer-sponsored retirement account, and they have distinct tax implications. The choice between the two depends on current and future taxation, as well as personal financial goals. Some individuals opt to use a combination of pre-tax, Roth, and after-tax contributions to diversify their tax exposure in retirement
After-Tax Contributions
- After-tax contributions to a 401(k) are made with income that has already been subject to income tax. This means that the money you contribute to your 401(k) account has already been taxed, and it does not provide any immediate tax benefits. These contributions are typically made after you have maxed out your pre-tax and Roth 401(k) contribution limits.
- While your contributions are made with after-tax dollars, the earnings on those contributions can grow tax-deferred. This means that you won’t owe taxes on the investment gains as long as the funds remain in the account.
- When you withdraw money from your after-tax 401(k) contributions, you will only owe taxes on the earnings or gains that have accumulated over time. Your original after-tax contributions are not taxed again upon withdrawal, as you’ve already paid taxes on them.
Roth 401(k) Contributions
- Roth 401(k) contributions are made with after-tax dollars, just like after-tax contributions. However, they are specifically designated as Roth contributions within your 401(k) plan.
- Roth 401(k) contributions provide tax benefits when you withdraw the money in retirement. Qualified distributions from a Roth 401(k) account are tax-free, meaning you won’t owe any income tax on the contributions or the earnings they have generated over time.
- Unlike traditional 401(k) contributions, Roth 401(k) contributions do not reduce your taxable income in the year you make them. Traditional 401(k) contributions are pre-tax, so they can lower your current tax liability.
- Roth 401(k) contributions are subject to income limits, so not everyone is eligible to make them. High-income earners may be restricted from contributing to a Roth 401(k).
In Summary
The primary difference between after-tax and Roth 401(k) contributions is the timing of taxation:
- After-tax 401(k) contributions are made with already taxed income, and you pay taxes on the earnings upon withdrawal.
- Roth 401(k) contributions are also made with after-tax income, but they offer tax-free withdrawals in retirement, and you don’t receive an immediate tax deduction for making them.
Rules and regulations are subject to change. Consult with a financial advisor or tax professional for personalized guidance on after-tax contributions and how they fit into your overall financial and retirement planning.
