Investors must weigh potential tax benefits against liquidity, other needs, when deciding where to steer extra contributions.
By Christine Benz | 08-13-17 | 05:00 AM | Email Article

The introduction of an aftertax 401(k) option at Morningstar a few years ago left a lot of my co-workers scratching their heads. Should I start making these contributions, my colleagues wondered, instead of traditional or Roth contributions?

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

In most cases, the confusion could be cleared up by asking a simple question. Are you already making the maximum contribution to a traditional or Roth 401(k)? If the answer was no, then my response was straightforward. "Forget about aftertax 401(k) contributions for now. Concentrate on making traditional (pretax) contributions or Roth contributions until you’re maxing them out."

That's because, from a tax standpoint, aftertax 401(k) contributions are a poor relation alongside traditional and Roth 401(k) contributions. With traditional contributions, the pretax money goes into the account and compounds on a tax-deferred basis; withdrawals are taxable at the individual's ordinary income tax rate. Roth 401(k) contributions receive the opposite tax treatment: Money that has already been taxed goes into the account, but then it compounds and can be withdrawn on a tax-free basis. (This article discusses which contribution type makes the most sense in a given situation. Spoiler alert: It's usually not black or white.)

By contrast, aftertax 401(k) contributions' tax benefits aren't as good. As with a Roth 401(k), aftertax dollars go into the aftertax 401(k). But while Roth contributions enjoy tax-free compounding from the get-go, aftertax 401(k) contributions compound on a tax-deferred basis. (Tax-deferred means that at least part of the assets will be taxable upon withdrawal, whereas tax-free is just what it sounds like.) Only when the employee retirees or separates from service, or the plan allows for what's called an "in-plan distribution," can the employee shunt the aftertax contributions over to a Roth IRA. Any investment earnings that have built up in the account can be rolled over to a traditional tax-deferred IRA, where those assets will be taxed upon withdrawal. In essence, the aftertax 401(k) maneuver allows contributors to amass tax-deferred assets, and the contributions to the account can become Roth assets at some later date. But the tax savings aren't as great with an aftertax 401(k) as they are with Roth or traditional 401(k)s.

Aftertax 401(k) vs. Taxable Account: A Case Study
If aftertax 401(k) contributions don't make sense for people who aren't already contributing the full $18,000 (under 50) or $24,000 (over 50) to the standard 401(k) types, who should consider them? The short answer is high-income folks who are maxing out their traditional or Roth 401(k)s--as well as other tax-sheltered savings opportunities like IRAs, HSAs, and 529s (if applicable)--but still have additional assets to invest. Such investors can stuff additional funds into an aftertax 401(k). For 2017, total 401(k) contributions--including traditional, Roth, employer matching, allocations of forfeitures, and aftertax contributions--can go as high as $54,000. Making aftertax 401(k) contributions can also make sense for higher-income couples with a single earner/access to a single 401(k) plan; after funding a spousal IRA for the nonearning spouse, contributing to an aftertax 401(k) can be a good move for amassing additional tax-favored assets.

What's the case for investing in an aftertax 401(k) versus a plain-old taxable brokerage account? Saving on taxes--perhaps not right away but down the line--is the main benefit. Investors in aftertax 401(k)s can take advantage of tax-deferred compounding and the ability to build additional assets in a Roth account, which will eventually enjoy tax-free withdrawals.

To illustrate, let's look at a (sorry, not all that) simple example. We'll assume 52-year-old Carol is maxing out all of the tax-sheltered options she can get her hands on, but she still has another $10,000 per year in aftertax dollars available to invest for the next 15 years prior to retirement. After that she'll hold the account for another 15 years and then begin drawing from it. She earns a 5% annualized return on her money over the 30-year period.

If she invested in a taxable account, we'd have to shave her annualized return, at least a bit, to account for the fact that she's subject to dividend and capital gains taxes during her accumulation period. Assuming a modest tax-cost ratio 0.5%, that takes her annualized return down to 4.5%. At the end of the 30-year period, her total pot would have grown to $402,231. If she were to begin withdrawing the money after 30 years, she'd owe capital gains taxes on the $252,231 of the account that represents investment appreciation. (She won't be taxed on her $150,000 in contributions again, because she made them with aftertax money.) Assuming a 15% capital gains tax rate (and it would actually be a bit lower because she has paid some taxes already), she'd have an aftertax balance of $364,396 available after 30 years.

If Carol invested that same $10,000 in an aftertax 401(k) for 15 years, she'd earn the full 5% on her money. Because the account is tax-deferred, she's not having to pay taxes on her money as it grows. (Dividends and capital gains distributions aren't taxed on a year-by-year basis as long as the money stays inside the tax-deferred account.) She'd have nearly $216,000 in the aftertax 401(k) after the first 15 years; let's assume she also retires at that point, at age 66. She could then take her $66,000 in investment gains and steer those funds to a traditional IRA. Her $150,000 in contributions could go into a Roth IRA at that time. Assuming both accounts earned a 5% annualized return for the next 15 years, she'd have $448,601 on a pretax basis. Withdrawals from the Roth account, totaling $311,839, would be tax-free, but she'd owe ordinary income tax on the $136,762 traditional IRA that has never been taxed. Assuming a 25% tax rate on the traditional IRA, her take-home aftertax amount would be $414,411--$50,000 ahead of the taxable-account investor. 

As the illustration shows, she really began cooking with gas in her account once she set up the Roth; the longer the money grows inside the Roth (i.e., the sooner it's removed from the confines of the aftertax 401(k)), the greater the tax benefits. That means that if a plan allows regular in-service distributions (it's possible for the employee to regularly roll over aftertax amounts to Roth), the tax benefits of the aftertax 401(k) are greater. In addition, if she wanted to give the money to her heirs rather than spend it during her own lifetime, the tax benefits of the Roth would be magnified over that longer period.

Mitigating Factors
All of the above assumes that the 401(k) is decent--that it includes low-cost investment options and doesn't feature a high layer of additional administrative expenses. If the 401(k) is particularly poor and/or costly, those drawbacks may offset the tax benefits of the aftertax 401(k)--and then some. In that instance, investing in low-cost investments inside of a taxable brokerage account is apt to be the better move.

There are also liquidity considerations to bear in mind. You can pull money from your taxable brokerage account at any time; the only taxes you'll owe would be capital gains taxes on the appreciation. Even though you're contributing aftertax dollars to your aftertax 401(k), you can't just withdraw the aftertax piece if you need to take your money out early. Rather, you'll owe taxes depending on the ratio of already-been-taxed monies to never-been-taxed monies. 

Finally, aftertax 401(k) contributions must be weighed against the investor's total opportunity set, taking into account not just the tax benefits but also the quality of the 401(k), the investor's asset allocation within it, and his or her time horizon, among other factors. For example, if an investor has a mortgage and plans to stay in his house after retirement, steering additional funds to prepay the mortgage is apt to beat investing funds in a conservatively positioned aftertax 401(k). This article takes a closer look at the importance of evaluating such trade-offs. 

Securities mentioned in this article

Ticker

Price($)

Change(%)
Morningstar Rating Morningstar Analyst Report
With Morningstar Analyst reports you can get our expert Buy/Sell opinions on over 3,900 Stock and Funds
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
Sponsored Links
Sponsor Center
Content Partners