Most know the importance for setting aside funds specifically earmarked for retirement, as conventional pension plans have all but faded into the distant past. Employees hold the majority of the savings burden on their shoulders these days if they want to generate income in retirement above and beyond what Social Security benefits may provider. While employer-sponsored retirement plans such as 401(k)s offer an easy way to shore up asset accumulation for retirement for most employees, there are lesser known tactics that can boost total savings each and every year.
Individuals under age 50 have the ability to save up to $18,000 in elective pre-tax deferrals within an employer-sponsored plan, while individuals over age 50 can set aside up to $24,000 each year. Although that may seem like a substantial amount, high earners or those decades away from reaching retirement age may find these contribution limits too low. Fortunately, under the 415(c)(1)(A) of the IRS tax code, total contribution limits for 401(a) defined contribution plans holds steady at $53,000 for the 2016 tax year, including all voluntary contributions and deferrals made by employers. Employees who have access to an employer-sponsored plan that falls within the category of defined contribution, like some 401(k) plans, can set aside funds above the $18,000 (or $24,000) threshold as after-tax contributions in an effort to save a greater amount. If you are already maxing out pre-tax contributions into your employer-sponsored plan, here are three reasons why it may be beneficial to consider adding after-tax contributions.
One of the greatest benefits to participating in an employer-sponsored plan is the ease of making contributions. Employees have the ability to select either a percentage of earnings or a specific dollar amount they want withheld from each paycheck to be set aside within the company’s retirement plan. Instead of requiring the willpower to receive earnings as a direct deposit and then place available savings into a retirement account, employer-sponsored plan contributions are made automatically from earnings.
Additionally, some plans establish automatic enrollment at the time an employee is hired to kick start savings. This means that a set portion of earnings is set aside automatically unless the employee elects otherwise. Automatic contributions that begin immediately upon hire help employees live off less from the start, creating an easy way to save toward retirement without giving it too much thought. While most automatic enrollment plans designate contributions as pre-tax, after-tax contributions, above the pre-tax limits, can easily be established at any time during employment.
Ability to Withdraw Contributions
After-tax contributions come with more benefits than simply saving more toward a retirement goal. Employees who make after-tax contributions to an employer-sponsored plan have the ability to withdraw these assets (subject to plan restrictions) without tax liability on the principal balance. Because taxes have already been paid on these contributions, employees do not owe Uncle Sam income tax on distributions of after-tax money, nor do they owe the 10% penalty imposed on withdraw taken prior to age 59 ½.
While an attractive benefit to after-tax contributions, savers beware. If investment gains are realized on these funds, taxes are owed on the earnings. It is important to consult with a tax advisor or financial professional prior to taking a distribution from after-tax assets within a 401(k) to ensure there are not better, more tax-beneficial solutions.
Tax Free Rollover to a Roth IRA
An additional benefit to making after-tax contributions is the ability to convert accumulated assets to a ROTH IRA. Individuals have the opportunity to generate tax-free income during retirement years by contributing to a ROTH IRA, but most higher income earners lose the ability to contribute to a ROTH due to IRS imposed income restrictions. Making after-tax contributions to an employer-sponsored plan is way around the income limits attached to a ROTH.
The IRS allows after-tax contributions to be rolled over to a ROTH IRA at the time an employee leaves an employer or retires – when 401(k) contributions are no longer available. Rolling over after-tax contributions to a ROTH allows investment earnings to grow on a tax-deferred basis until they are withdrawn, at which time they are tax-free. The ability to generate income free of tax during retirement years is something all savers should strive to achieve.
Although making after-tax contributions are not on the radar for all income earners, the strategy provides a method to set aside additional funds specifically for retirement for individuals who are already maxing out pre-tax or ROTH contributions with an employer-sponsored plan. After-tax contributions can work well in achieving a greater retirement savings goal, and ensuring enough dollars are set aside to live comfortably after income-earning years have passed.