What are After-Tax Contributions?
After-tax contributions refer to money that is contributed to a retirement savings account, such as a 401(k) contribution or IRA, after taxes have already been paid on the income. Unlike pre-tax contributions, which reduce your taxable income in the year of the contribution, after-tax contributions do not provide an immediate tax benefit.
However, any investment earnings on after-tax contributions grow tax-deferred, and withdrawals in retirement are taxed at the lower capital gains tax rate rather than the higher ordinary income tax rate. After-tax contributions can be a useful way to save additional funds for retirement beyond the limits of pre-tax contributions.
Is It Better to Contribute Pre-Tax or After Tax?
Whether it’s better to contribute pre-tax or after-tax depends on your financial situation and goals.
Pre-tax contributions, such as those made to a traditional 401(k) or IRA, reduce your taxable income in the contribution year, which can lower your tax bill and increase your take-home pay. However, withdrawals from pre-tax accounts in retirement are taxed at your ordinary income tax rate, which may be higher than the tax rate on your pre-tax contributions.
After-tax contributions, such as those made to a Roth 401(k) or Roth IRA, do not provide an immediate tax benefit. Still, any investment earnings on after-tax contributions grow tax-free, and qualified withdrawals in retirement are also tax-free. This can be advantageous if you expect your retirement tax rate to be higher than it is currently.
How are After Tax Contributions Recovered?
After-tax contributions to a retirement account, such as a 401(k) or IRA, are recovered tax-free when they are withdrawn in retirement.
When you withdraw after-tax contributions from a retirement account, such as a Roth 401(k) or Roth IRA, you do not have to pay taxes on the amount of the contribution itself since taxes were already paid on that income. However, any investment earnings on after-tax contributions are subject to taxes if withdrawn before age 59 1/2 or if the withdrawal is not considered a qualified distribution.
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