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What are After-Tax Contributions?
After-Tax Contributions: Money that is contributed to a retirement savings account (like a 401(k) contribution or IRA) after taxes have already been paid on it. Pre-tax contributions lower your taxable income in the year you contribute, whereas after-tax contributions offer no up-front tax break.
However, investment earnings on After-Tax contributions can grow tax-deferred, and once the account holder retires, withdrawals from this portion of their 401 (k) will be taxed at the lower capital gains tax rate rather than the higher ordinary income tax rate. That said, after-tax contributions can be an effective way to save additional funds for retirement with more than standard allowances for pre-tax contributions.
Is It Better to Contribute Pre-Tax or After-Tax?
Whether a pre-tax or after-tax contribution is better depends on each individual’s financial situation and goals.
Contributions made on a pre-tax basis, like those to a traditional 401(k) or IRA, reduce your taxable income in the contribution year and could result in lower taxes owed and more after-tax take-home pay. On the other hand, distributions from pre-tax accounts in retirement are taxed at your ordinary income tax rate (unless you live somewhere like Florida or Texas with no state income tax), which could be higher than when you made those pre-tax contributions to those same accounts.
Some are pre-tax contributions, such as those made to a traditional 401(k) or IRA, while after-tax contributions — say to a Roth 401(k) or Roth IRA — do not create any up-front tax break at all. Nevertheless, investment earnings on after-tax contributions will still accumulate tax-free, and qualified withdrawals in retirement will be tax-free as well. This can work in your favor if you anticipate that your tax rate during retirement will be higher than it is today.
How are After Tax Contributions Recovered?
As it happens, after-tax contributions made to a retirement account (like, say, a 401(k) or IRA) are then pulled out when you retire, tax-free from income tax.
If you pull out after-tax contributions from a retirement account like a Roth 401(k) or Roth IRA, then you should not be required to pay taxes on that contribution because it was already taxed! However, investment earnings on after-tax contributions are also taxed when they’re withdrawn if the distribution is taken before age 59 1/2 or if it’s not a qualified distribution.
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