Treavor Dodsworth CFP®, CPA, CKA®
#95 - The Little Known 401k Contribution
At some point throughout someone's working career, they will likely have the option to contribute to a 401k or similar type of account. These accounts oftentimes allow for at least two options - contributing on a traditional or pre-tax basis (generally tax deduction today but pay tax later) or Roth basis (generally no tax deduction today but tax-free later). Occasionally a few of these accounts may allow for a third type of contribution - after-tax contributions. Although after-tax contributions are occasionally confused with the Roth, it is not the same. Like the Roth contributions, there is no tax deduction for contributions but unlike the Roth contributions earnings grow tax-deferred (generally pay ordinary income tax on them later) instead of tax-free. Also, unlike the Roth option contribution limits can potentially be much higher (over $50,000 a year). There are two primary reasons to be aware that these contribution types exist.
Although there are likely other investment vehicles you would consider first, after-tax contributions to a 401k can potentially be quite lucrative. Primarily because it is occasionally possible to do an in-service distribution and roll the after-tax contributions to a Roth IRA (effectively getting $50K+ into a Roth IRA). Even if that is not possible to do while working, it is likely possible that you could move the after-tax contributions to a Roth when you separate from service. Once in the Roth, growth changes from being tax-deferred to tax-free. There are many nuances here (how earnings are treated, etc.) and this won't make sense for everyone even if it is an option.
To a certain extent, some of the tracking of contribution types falls on the individual investor. Let’s say you made an after-tax contribution and didn’t realize it and later you rolled that money to a Traditional IRA. If you didn’t track the basis in your Traditional IRA, you may accidentally pay tax on that money twice when you later withdraw it from the Traditional IRA.
For many, after-tax contributions will never be relevant but for others, the impact can be very substantial.
Interesting Article(s) or Video(s)
Eternal Perspective Ministries - He Turned His Business over to God: Stanley Tam's Story
Randy Alcorn shares a brief summary of Stanley Tam’s incredible example. I hope this read is challenging, humbling, and motivating for you.
Thank you for reading!