Are After Tax 401(k) Contributions a Good Idea?
From the 401(k) Manual:
"If you choose to contribute to the plan on an after-tax basis, IBM deducts contributions from your pay after taxes have been calculated. Therefore, after-tax contributions don't reduce your taxable income.
Because you've already been taxed on your after-tax contributions, you won't be taxed again when you withdraw those contributions from the plan. However, you'll be taxed on the investment earnings when you take a withdrawal."
However, the reason after tax contributions to a 401(k) aren't ideal is that any proceeds withdrawn at retirement are taxed at ordinary income rates. This means that your profits could be taxed at regular income tax rates instead of the currently lower capital gains income tax rates.
If your not already maxing out the pre-tax 401(k), Roth IRA, ESA, and 529 plan (if applicable) contributions, all of these plan are more desirable from a tax perspective by offering tax deferral (401k, 529 plan), or tax avoidance (Roth IRA or ESA on gains).
After-tax contributions to a 401(k) don't have any tax benefit, instead they sort of have a tax penalty - your likely to pay more tax when you withdraw than if you put the money in a taxable account. However, after-tax contributions to a 401(k) do have a big benefit (at least in my case). The investments choices have significantly lower expense/maintenance fees than their public mutual fund counterparts.
Can the lower fees offset the extra tax?
If you have already maxed out you other accounts with tax benefits, lets find out if the lower maintenance fees could offset the tax penalty. For example IBM's 401(k) plan has a Small Cap Value Index Fund with an amazingly low expense ratio of just .04% compared to 0.23% for Vanguard's Small Cap Value Index Fund. The 401(k) fund has less than 1/5 the cost than the comparable Vanguard fund has - it seems like these annual fees could add up over the years.
Lets work through a scenario to see which kind of account would come out ahead. Will assume we are investing $10,000 a year in either the 401(k) plan's and Vanguard's Small Cap Value Fund. We will assume we will make investments for the next 21 yrs and to simplify things we will assume the funds will both return 10% each year. Obviously we know the fund with the lower fees will be worth more, but will it be enough to offset the extra taxes we would need to pay?
Note: To simplify things I am not deducting the expense ratio fees from the investment, these fees would normally reduce the total investment, however this won't affect the outcome of this scenario
| | Contribution | Yr End Value | IBM Fees | Vang. Fees |
| 2005 | $ 10,000.00 | $ 11,000.00 | $ 4.40 | $ 25.30 |
| 2006 | $ 10,000.00 | $ 23,100.00 | $ 9.24 | $ 53.13 |
| 2007 | $ 10,000.00 | $ 36,410.00 | $ 14.56 | $ 83.74 |
| 2008 | $ 10,000.00 | $ 51,051.00 | $ 20.42 | $ 117.42 |
| 2009 | $ 10,000.00 | $ 67,156.10 | $ 26.86 | $ 154.46 |
| 2010 | $ 10,000.00 | $ 84,871.71 | $ 33.95 | $ 195.20 |
| 2011 | $ 10,000.00 | $ 104,358.88 | $ 41.74 | $ 240.03 |
| 2012 | $ 10,000.00 | $ 125,794.77 | $ 50.32 | $ 289.33 |
| 2013 | $ 10,000.00 | $ 149,374.25 | $ 59.75 | $ 343.56 |
| 2014 | $ 10,000.00 | $ 175,311.67 | $ 70.12 | $ 403.22 |
| 2015 | $ 10,000.00 | $ 203,842.84 | $ 81.54 | $ 468.84 |
| 2016 | $ 10,000.00 | $ 235,227.12 | $ 94.09 | $ 541.02 |
| 2017 | $ 10,000.00 | $ 269,749.83 | $ 107.90 | $ 620.42 |
| 2018 | $ 10,000.00 | $ 307,724.82 | $ 123.09 | $ 707.77 |
| 2019 | $ 10,000.00 | $ 349,497.30 | $ 139.80 | $ 803.84 |
| 2020 | $ 10,000.00 | $ 395,447.03 | $ 158.18 | $ 909.53 |
| 2021 | $ 10,000.00 | $ 445,991.73 | $ 178.40 | $ 1,025.78 |
| 2022 | $ 10,000.00 | $ 501,590.90 | $ 200.64 | $ 1,153.66 |
| 2023 | $ 10,000.00 | $ 562,749.99 | $ 225.10 | $ 1,294.32 |
| 2024 | $ 10,000.00 | $ 630,024.99 | $ 252.01 | $ 1,449.06 |
| 2025 | $ 10,000.00 | $ 704,027.49 | $ 281.61 | $ 1,619.26 |
| Total | $210,000.00 | $ 704,027.49 | $ 2,173.72 | $ 12,498.90 |
In this example, we have contributed $210,000 and its now worth $704,000 (ignoring fees). Not bad at all. Its clear we would have saved at least $10,324.88 over the years in expense fees just by making out after-tax contributions to the 401(k) plan.
Note: We actually would have saved a bit more since the fees would be deducted each year instead of the end reducing our compounding investment.
But what happens after we pay tax on this? In both accounts we would have $704,000 - $210,000 = $494,000 of gains that would be taxed. If tax rates remain the same as the do today; the difference between long term capital gains and ordinary income rates would be about 10% or $49,400. Wow!
This would mean the after-tax contributions to the 401(k) plan would cost an extra $49,400 (extra taxes paid) - $10,324 (the amount of extra maintenance fees we would pay) = $39,075 over just sticking the contributions in a comparable taxable Vanguard fund account.
I think I'll do my best to avoid after-tax contributions to my 401(k) from here on out and stick them in low-cost mutual funds instead.
Comments (14)
DATE: 10:59 AM
2million, Your analysis shows the after tax contributions to a 401k are not a good idea. This point is even truer if you may need the money before age 55. If the money is in a regular taxable account you can withdraw money any time without a penalty. From a 401k account there is a 10% penalty for early withdrawal in most cases.
Posted by j | September 10, 2006 3:17 PM
DATE: 11:17 AM
good point - i forgot to mention that.
Posted by 2million | September 10, 2006 3:17 PM
DATE: 1:06 PM
One of the things missing from your analysis is the fact that some taxes would be due during the accumulation period. Even if you are in a low cost MF, there are still annual dividends and CG distributed. If, at some point, you decide to change to a different fund, you will then owe taxes on all of the accumulated CGs.Inside a tax deferred structure, you are free to make changes as needed.
Posted by LAMoneyGuy | September 10, 2006 3:17 PM
DATE: 1:28 PM
Yes I thought about that but decided to keep it simple and ignore that (probably should have pointed that out though). Any suggestions on how to incorporate that in the scenario to accurately reflect that? I don't have any good ideas of have to factor that in. Is there an avg capital gain distribution for mutual funds that I could use as an assumption?
Posted by 2million | September 10, 2006 3:17 PM
DATE: 2:34 AM
$2M,A couple of thoughts regarding your analysis:a. I think the biggest question is whether capital gains will continue to receive favourable tax treatment - they may not - there is no legislative guarantee, esp. if Democrats are elected.b. another benefit of putting the money in the 401k is that it's protected from 3rd party creditors - this is great if you experience some form of catastrophic liability.c. j has a great point about the money not being available.d. use ETFs, which have much lower capital gains distributions than mutual funds.e. one point to incorporate into your table is the earnings the money you save on fees generates. It's especially important in the later years.Good luck and have a great day,makingourway
Posted by makingourway | September 10, 2006 3:17 PM
DATE: 4:46 AM
2million,Nice analysis. However, you're assuming that you'd stick with the same investment for 20 years and not change your investments. In reality, most people change their investment strategies and incur capital gains multiple times over the course of 20 years. If you think you'll do this, the 401(k) might be the way to go.
Posted by Wes | September 10, 2006 3:17 PM
DATE: 3:35 PM
The real problem is that excess contributions are taxed twice. That is, they are included in your income for taxation purposes in the year they are contributed, and they are not excluded from your distributions when you take them. It is explained here:http://www.irs.gov/retirement/participant/article/0,,id=151786,00.htmlGiven this, after-tax contributions are a non-starter.
Posted by Anonymous | September 10, 2006 3:17 PM
DATE: 3:40 PM
After re-reading your post, I think IBM is just wrong.
Posted by Anonymous | September 10, 2006 3:17 PM
DATE: 3:54 PM
I'm no expert, but I think you might be confused - these aren't excess deferrals (which end up tax twiced), these are after tax contributions.I can't find the IRS bulletin that goes into detail on this, but I have read in multiple places (such as http://invest-faq.com/articles/ret-plan-401k.html) about after tax contributions to 401(k)s.
Posted by 2million | September 10, 2006 3:17 PM
DATE: 8:05 AM
Once you hit the limit, I can only see contributions working in two ways:1) They are classified as "excess deferrals". They remain in your 401(k) and are treated as described in the document I linked above.2) They are placed in a separate account, which has the same investment options as your 401(k). I cannot find where the IRS makes any mention of an "after-tax 401(k)", so this would be simply an after-tax investment account. The entire balance should be available to you at any time, without penalty, and you should only owe capital gains, not income taxes.If you can find IRS documentation that contradicts this, please advise. Thanks.
Posted by Anonymous | September 10, 2006 3:17 PM
DATE: 11:24 AM
Typically, benefit plans that offer post-tax contributions once contribution limits are reached are not considered excess contributions - you won't find these addressed explicitly by section 401(k) because the code only applies to "real" tax-deferred 401(k) contributions. Post-tax contributions are technically not 401(k) contributions - as noted in a preceding post, they represent a discrete after-tax investment that is managed by the same trustee as the 401(k) account, and usually appears semi-transparently as part of the overall 401(k) balance. While it's possible there may be minimal benefit to saving this way, depending on your plan's performance, chances are you will at least benefit from the lower fees typical of an institutional investment. One additional thing to consider - and this is potentially a big benefit - your employer may continue to match post-tax contributions, which automatically increases your rate of return. Check with the plan administrator, but most likely, your post-tax CONTRIBUTIONS are available for withdrawal at any time, with any earnings subject to tax and - maybe - penalties (think of it as a nondeductible IRA).
Posted by Anonymous | September 10, 2006 3:17 PM
Do you think you could do another example where the employer match continues? Some plans provide employer match on after tax contributions. Thus, there is the benefit of: 1) the "additional" match on the after tax contrib (assume 4-7% match--which seems representative of a lot of plans), and 2) the growth of these contributions. I am not sure if the contributions/compounding would offset the tax implication though...and it would help me out to see an example. How much would the compounded delta (that arises from additional match and compounding on the additional match) be worth? Would it be great enough to offset the loss of the CG tax benefit that would come from a separate account?
Posted by mw | March 1, 2008 5:39 PM
The last post in this chain I can see is by Anonimous Sep.10 2006 3:17 pm, where the question is raised re: another example that would show the effect of employer match contributions. How can I see the rest of this chain?
Posted by Sam | May 6, 2008 10:20 AM
I actually love the fact that I can do after tax contrabutions. here is why
1. 401k already maxed out.
2. It allows me to invest in funds I normally could not afford the min. investment on myself
Posted by D3 | May 12, 2008 3:22 PM