After-Tax Contributions: What They Are and How They Work
Contributions to retirement accounts funded with money that have previously had federal taxes deducted would be called After-tax contributions. Since these contributions are made using money that has already had taxes paid at the federal level, you will not be able to reduce your taxable income for that tax year.
An employee may make after-tax contributions to a qualified retirement plan that contains provisions for after-tax contributions (possibly called a 401(k) plan), depending upon the retirement plan. These contributions are not the same as traditional contributions made before taxes (pre-tax) or contributions made to Roth IRAs or Roth 401(k)s under the rules established by the Internal Revenue Service (IRS).
You should understand how after-tax contributions are treated for taxation and how they are treated when withdrawn for purposes of planning for retirement and accurate reporting of income taxes.
What Are After-Tax Contributions?
After-tax contributions to a retirement account are made with money that has already been taxed at the federal level before being deposited into the fund.
The following are the major characteristics of after-tax contributions:
- An after-tax contribution will not reduce your taxable income during the year it was deposited.
- Your original contribution (or principal) can usually be withdrawn without paying income tax, because you paid taxes on it before depositing it into the retirement plan.
- Any investment earnings from an after-tax contribution will be subject to tax when you withdraw that money, with the exception of those funds that you want to move to a Roth IRA through a permitted rollover.
For instance, after-tax contributions to a traditional 401k account will have already been taxed at the time of deposit. However, any investment returns from those initial contributions will generally be taxed as regular income upon withdrawal.
Pre-Tax vs. After-Tax vs. Roth Contributions
Choosing the right contribution type depends on factors such as your income level, expected tax bracket in retirement, and cash-flow needs.
Pre-Tax Contributions
While traditional retirement Accounts (like a Traditional 401(k) or Traditional IRA) are funded with pre-tax dollars:
- Reduce your taxable income for the current tax year
- Withdrawals during retirement are taxed as ordinary income
After-Tax Contributions
These are non-deductible contributions made with money that has already been taxed.
- No immediate tax deduction
- Original contributions are not taxed again when withdrawn
- Earnings are taxable as ordinary income
Roth Contributions
Accounts like the Roth 401(k) or Roth IRA are also funded with after-tax dollars, but they have a key advantage.
- Contributions are not tax-deductible
- Qualified withdrawals of both contributions and earnings are tax-free under IRS rules
Many individuals who expect to be in a higher tax bracket during retirement prefer Roth accounts because they allow tax-free income later.
How After-Tax Withdrawals Are Taxed
According to IRS distribution rules, withdrawals from retirement accounts consist of two parts:
- Contributions (principal)
- Investment earnings
With after-tax contributions:
- The principal is not taxed again when withdrawn.
- Earnings are typically taxed as ordinary income.
If withdrawals occur before age 59½, the earnings portion may also be subject to a 10% early withdrawal penalty, unless an IRS exception applies.
In some employer plans, savers may also convert after-tax funds into a Roth account through a rollover strategy, which can allow future earnings to grow tax-free if IRS requirements are met.