Most 401k plan providers will offer two different contribution options: Traditional pre-tax and Roth post-tax.
Traditional pre-tax contributions are funded with pre-tax income, give you a tax deduction for the year, and grow tax-deferred. When you withdraw in retirement, it gets taxed as regular income.
Roth post-tax contributions are funded with post-tax income, and don’t give you any tax breaks when you contribute. However, withdrawals in retirement are completely tax-free.
Some 401k plans will also offer a third type of account: The after-tax 401k.
What is an after-tax 401k?
An after-tax 401k is often confused with a Roth 401k since they’re both funded with post-tax income (money you’ve already paid income taxes on).
The difference is that with a Roth 401k, your contributions grow tax-free and you don’t have to pay any taxes when you make withdrawals in retirement. With an after-tax 401k, contributions can be withdrawn tax-free, but you’ll have to pay income taxes on any gains.
When does contributing to an after-tax 401k make sense?
If withdrawals in retirement are tax-free for a Roth 401k, but not for an after-tax 401k, why would anyone choose to contribute to an after-tax 401k over a Roth 401k?
The short answer is, they wouldn’t.
There are two main reasons for contributing to an after-tax 401k.
- To put more money into a 401k after maxing out employee contributions for the year.
- To do a mega backdoor Roth conversion.
Let’s go through them below.
Reason #1: Put more money into a 401k
The purpose of an after-tax 401k is to provide an additional savings option for any employees who’ve maximized their contributions to a traditional 401k or Roth 401k.
The employee contribution limit for a traditional or Roth 401k is $20,500 ($27,000 if age 50+) for 2022 and $22,500 ($30,000 if age 50+) for 2023. An after-tax 401k doesn’t have its own contribution limit and you can contribute up to the contribution limit of a 401k plan, which is $61,000 for 2022 and $66,000 for 2023.
If you max out your Roth 401k for 2022, you would still have $40,500 in room left over to make contributions to your after-tax 401k. If you max out your Roth 401k for 2023, you would still have $42,500 in room left over to make contributions to your after-tax 401k.
While you don’t get any tax deductions for contributions to an after-tax 401k, the earnings are still tax-deferred until retirement.
Reason #2: Do a mega backdoor conversion
The more popular use for an after-tax 401k is to use it as a vehicle to implement a mega backdoor Roth conversion, which allows you to put more money into a Roth retirement account than is typically allowed by the IRS.
Here’s how it works. After contributing money into your after-tax 401k, it gets immediately converted into a Roth retirement account of your choice. You can do a mega backdoor Roth conversion into a Roth IRA, Roth 401k, or a Roth solo 401k. Because contributions were made with income that you already paid taxes, transferring it to another Roth retirement account is not a taxable event.
A mega backdoor Roth conversion is only possible if your 401k or solo 401k plan provider offers both:
- After-tax contributions and
- In-plan Roth conversions.
The Ocho Solo 401k Plan offers both options.
Examples of using the after-tax 401k for a mega backdoor Roth conversion
Let’s go through a few examples of what a mega backdoor Roth conversion might look like in practice.
Example #1: Roth solo 401k
John has a solo 401k and wants to make contributions for 2022. For the 2022 tax year, the 401k contribution limit is $61,000. As an employee of his business, he can contribute up to $20,500 and he’s able to choose whether it goes into a traditional pre-tax solo 401k or a Roth post-tax solo 401k. John chooses the Roth option and contributes the maximum amount of $20,500.
Out of the 401k contribution limit, John contributed the maximum on the employee side. Now, he has $40,500 ($61,000 limit minus $20,500 employee contribution) in room remaining. With a solo 401k, John can make additional contributions as the employer of the business. However, employer contributions can only be made as pre-tax, without an option for Roth. Therefore, John decides to make use of the after-tax 401k in order to do the mega backdoor Roth conversion.
John contributes $40,500 into his after-tax account and then immediately converts it into his Roth solo 401k. Now, for 2022, John has deposited $61,000 (the entire 401k limit for the year) into his Roth solo 401k.
Example #2: Roth IRA
In this example, John has a full-time job and receives a 401k from his employer. The year is 2022 and he wants to maximize his Roth contributions. The problem is that John made too much income this year, causing him to exceed the Roth IRA income limits. In 2022, you cannot contribute to a Roth IRA if your income is over $144,000.
Fortunately, John’s 401k plan also offers an after-tax 401k. He decides to max out his Roth 401k plan first and contributes $20,500. He also receives a 401k employer match of $3,000. That leaves him with $37,500 ($61,000 minus $20,500 contribution minus $3,000 employer match) in room remaining to do a mega backdoor Roth conversion.
John contributes $37,500 into his after-tax 401k plan and immediately converts it into his Roth IRA. The income limits of a Roth IRA only applies to contributions; there are no income limits or restrictions around transferring money from one plan to another. Because he already paid taxes on his after-tax contributions, the transfer is not a taxable event.
Note: John could also have decided to transfer the money into his Roth 401k instead of his Roth IRA. However, he decided to transfer it into his Roth IRA since it gave him more investment options than his 401k plan.
Should I transfer my after-tax funds into a Roth 401k, Roth IRA, or Roth solo 401k?
Once you have funds in your after-tax 401k, you can choose where to transfer the funds after doing the mega backdoor Roth conversion. If you have a Roth 401k from your employer, a Roth IRA, and a Roth solo 401k, you should opt to move the funds into the account that gives you the most investment options. In most cases, that’s going to be your Roth solo 401k.
With a Roth 401k, your investment options are usually limited to around a dozen mutual funds selected by your employer. With a Roth IRA, you’ll be able to invest in most traditional assets like individual stocks, bonds, mutual funds, and ETFs. With a solo 401k, many plan providers will allow you to invest in any asset class including alternative investments like crypto, real estate, and private equity.
Not all solo 401k plans offer the ability to invest in any asset class. You can compare the best solo 401k plan providers here.
What’s the difference between a Roth 401k and an after-tax 401k?
Contributions for both the Roth 401k and the after-tax 401k are made with post-tax income (money you’ve already paid taxes on). However, the difference is that your Roth 401k grows tax-free and your after-tax 401k grows tax-deferred.
With a Roth 401k, you don’t pay any taxes when you withdraw in retirement. With an after-tax 401k, you’re required to pay income taxes on the gains in your account. For a regular contribution, when you have the option to choose between a Roth 401k and an after-tax 401k, you should always prioritize maxing out your Roth 401k first. The after-tax account is optional and should only be used if you want to put more money into your 401k after maxing out your employee contributions, or if you want to do a mega backdoor Roth conversion.