[Note: The words post-tax and after-tax will be used interchangeably during the course of this article. Post-tax refers to contributions made to a retirement account where you do not get a deduction when the money goes in, yet the growth stays tax-deferred. Pre-tax refers to money that is yet to be taxed, so it is in a tax deferred state. The terms 401(k) and 403(b) will be used interchangeably during this article. I strongly recommend reading this post before reading this article to understand the different terms that will be used. Please note the website disclosure statement]
Did you know that I love a good caveat? It seemingly accompanies everything in life: You can have extra sour cream on your burrito, but that will be an additional dollar. You can drive a car anywhere in the United States, but only if you have a driver’s license. The list goes on, but for today’s article, we will hone in on a caveat that I find fascinating: After-tax investing in pre-tax accounts.
It sounds like a counterintuitive concept, doesn’t it? Before we dive into what this means, a refresher is in order: After-tax investing refers to investing monies after taxes have been paid, hence the name. Most commonly, after-tax investing is done within non-preferential taxable accounts. In these accounts, taxes are triggered whenever investment activity occurs (i.e., trades, dividends, interest, and etc.).
Plain English translation: If you make money, you will pay taxes on it when you file your next tax return.
Alas, this is not the focus of today’s article, though. Instead, we will be focusing on after-tax investing through tax-deferred accounts! That is right, not Roth accounts but traditional pre-tax accounts. Sounds wrong, doesn’t it? Well, as one of my favorite songs would say: It is so wrong, it’s right.
This concept can be quite advantageous, so let us see how it works before you write it off. (See what I did there?)
•A $1,000 after-tax contribution is made to a traditional IRA or 401(k)
•Ten years later, the money has grown to $10,000
•The money is then entirely withdrawn
•$1,000 is returned to you without taxes being owed
•The remaining $9,000 is returned to you, but you will pay income taxes on it
Make sense? Because you paid taxes on the original contribution, Uncle Sam is nice enough not to tax that amount again. On the other hand, this is not a Roth account, so the growth is not tax-free. Instead, you defer paying taxes on this growth until you take that money out. (This is a tax-deferred account, after all!)
Thus, when the additional $9,000 is withdrawn at the end of ten years, income taxes are owed since they never were paid. Uncle Sam has been patiently waiting for his cut, and your withdrawal is music to his ears.
So what tax-deferred accounts allow after-tax contributions? Thanks for asking, they include: The 401(k), 403(b), and traditional IRA. With IRA accounts, you can always make an after-tax contribution to them, period. It does not matter what your income is and what other accounts you have. For 401(k) and 403(b) accounts, you can only make them if your company allows it.
But why would I make an after-tax contribution? Whoa, you must be psychic! Various reasons exist but most commonly: To save in a tax-preferential way for all growth, maximize your retirement contribution limits, and take advantage of backdoor Roth conversions.
As I cover in the post, Is there a FIRE backdoor? Some people cannot make a tax-deferred contribution to their IRA. Some 401(k) and 403(b) plans allow you to save above the standard limits via after-tax. Most importantly for both of these, though, is the third reason, and that is for backdoor conversions! For those who cannot make Roth IRA contributions, the backdoor Roth IRA conversion is a great strategy. Additionally, for those allowed to through their 401(k), the mega backdoor Roth conversion is a saver’s dream! To read more, check out this post on after-tax conversions.
One last topic to note is that if you decide to make after-tax contributions to a traditional IRA and not convert them, you will then have to file Form 8606 with the IRS each year. Why? So that both you and Uncle Sam can keep track of what is taxable and what is not for when you withdraw it someday. Filing this form does not apply to 401(k) and 403(b) accounts since the company that holds them must keep track of the amounts for you!
What do you do? Have you ever made and after-tax contribution to an IRA or 401(k)? Let me know and tell me why in the comments below!
Mile High Finance Guy
finance demystified, one mountain at a time