The Hidden Power of After-Tax Contributions

By Sarah Carlson, CFP®, CLU®, ChFC®

When it comes to planning for retirement, there are a myriad of strategies and options available. One often overlooked method is making after-tax contributions into retirement savings vehicles. This approach to investing after-tax dollars may significantly increase one's retirement savings and help reduce taxes in retirement.

This article discusses the mechanics of after-tax contributions, how to leverage them, tax-advantaged investments, and the Backdoor Roth IRA strategy.

What exactly are after-tax contributions?

Before diving deeper into the topic, it's vital to understand the term 'after-tax contributions.' Making an after-tax contribution to an account involves money that has already been taxed. This action contrasts with pre-tax contributions, where monies are deposited into the account before it is taxed, reducing one's taxable income.

After-tax contributions may allow for greater flexibility compared to their pre-tax counterparts regarding when you can start distributions without penalty. After-tax accounts do not always have the same stipulations. This flexibility may benefit those who want to retire early or anticipate needing access to their retirement funds before the regular retirement age.

Leveraging After-Tax Contributions

Given the benefits of after-tax contributions, it's worth exploring how to leverage them. The most common way to make after-tax contributions is through a Roth 401(k) or Roth IRA. While there are limitations on who can contribute directly to a Roth IRA based on income levels, many employer-sponsored 401(k) plans now offer a Roth option.

In the case of a Roth IRA, the contribution and accumulation are tax-free when withdrawn if the account owner is 59 ½ or older or the account has been open for more than five years.

Other vehicles with after-tax contributions and tax-free withdrawals include:

• Municipal bonds—Depending on where they were issued and purchased, Municipal bonds are tax-free at the Federal level and may be tax-free at the state and local levels.
• Tax-exempt mutual funds and ETFs—These funds are comprised of tax-exempt strategies, ETFs, and bonds.
• Cash value life insurance—These policies are purchased with after-tax monies. They offer a death benefit and cash value growth that can be accessed tax-free as a policy loan under current tax laws, making them a suitable saving strategy for some.

Additionally, after-tax contributions to the above vehicles can lead to a more significant nest egg for retirement as they are not subject to the same annual contribution limits as other accounts. The higher contribution limit is particularly beneficial for high earners who can't contribute to a Roth IRA due to the IRS income cap.

Tax-free withdrawals

The main benefit of after-tax contributions for investors is the tax-free withdrawal feature, given certain conditions are met. While the growth portion of after-tax contributions may be subject to taxation upon withdrawal, the original contribution is tax-free.

This tax break is powerful when it comes to compound interest. Growing investments over several years, or even decades, without taxation can significantly increase the overall accumulation of one's retirement savings.

Backdoor Roth IRA strategy

Another strategy is the backdoor Roth IRA, which allows high-income earners to convert their IRA funds to a Roth IRA. However, it's important to note that taxes will be due on the amount transferred to a Roth IRA for the tax year the backdoor strategy occurred.

Additionally, if a 401(k) plan allows, the 401(k) funds can transfer to an IRA and later to a Roth IRA.

This strategy requires careful planning and an understanding of tax rules, but it can offer substantial tax savings for those who can utilize it. Before implementing it, it is vital to meet with financial and tax professionals to understand how this strategy works and its tax implications.

After-tax contributions to retirement savings vehicles are powerful because they can provide tax-free income later, flexibility in accessing funds, and potentially a larger pool of retirement assets to draw from. By understanding how after-tax contributions can play a critical role in saving for retirement, one can determine if these strategies are suitable for their situation.

Remember, thoughtful financial planning is vital for an independent retirement. Therefore, working with a financial professional to help implement these strategies may be beneficial.

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Important Disclosures:

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking tax, legal or investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.

Investing involves risks including possible loss of principal.

Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.  If sold prior to maturity, capital gains tax could apply.

Although exchange traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors.

All guarantees and benefits of the insurance policy are subject to the claims-paying ability of the issuing insurance company.

The tax-loss harvesting and other tax strategies discussed should not be interpreted as tax advice and there is no representation that such strategies will result in any particular tax consequence. Clients should consult with their personal tax advisors regarding the tax consequences of investing.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

This article was prepared by Fresh Finance.

LPL Tracking #666420

Sources:

https://money.usnews.com/investing/articles/are-there-any-tax-free-investments

https://www.investopedia.com/terms/b/backdoor-roth-ira.asp#:~:text=A%20backdoor%20Roth%20IRA%20is,IRA%20to%20a%20Roth%20IRA.