2million - My Journey to Financial Freedom

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Friday, May 05, 2006

Are After Tax 401(k) Contributions a Good Idea?

I don't know how many 401(k) plans offer this feature, but IBM's plan allows employees to contribute up to 10% of their salary (on an after-tax basis) to their 401(k). These after-tax contributions are not part of a Roth 401(k) feature, nor do they count towards the IRS 401(k) pre-tax contribution limit ($15,000 in 2006).

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However, the reason after tax contributions to a 401(k) aren't ideal is that any proceeds withdrawn at retirement are taxed at ordinary income rates.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.

29 Comments:

  • 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.

    By Anonymous j, at 10:59 AM  

  • good point - i forgot to mention that.

    By Blogger 2million, at 11:17 AM  

  • 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.

    By Anonymous LAMoneyGuy, at 1:06 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?

    By Blogger 2million, at 1:28 PM  

  • $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

    By Blogger makingourway, at 2:34 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.

    By Anonymous Wes, at 4:46 AM  

  • 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.html

    Given this, after-tax contributions are a non-starter.

    By Anonymous Anonymous, at 3:35 PM  

  • After re-reading your post, I think IBM is just wrong.

    By Anonymous Anonymous, at 3:40 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.

    By Blogger 2million, at 3:54 PM  

  • 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.

    By Anonymous Anonymous, at 8:05 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).

    By Anonymous Anonymous, at 11:24 AM  

  • Let's say I make after-tax contributions to my 401(k). You main point is that my gains would be taxed at regular income tax, instead of the current 15% long-term capital gains tax.

    As of right now, the highest tax bracket I reach is 25% after deductions.

    Let's say that when I make withdrawls, I quit my regular job and take a low-paying job that places me in the 15% bracket.

    Or I don't work at all.

    Then how would my gains be taxed?

    Thanks!

    By Anonymous Anonymous, at 8:50 AM  

  • You are assuming that all investments are withdrawn at the same time. Usually, only a small portion is withdrawn each year. Therefore, the tax bracket could potentially be lower at 10%.

    E.g.
    To make it simpler, let's say I started making after-tax contributions 40 years ago, and I am ready to retire and withdraw from my 401(k) today (let's assume they existed back then).

    Using 2006 tax brackets for singles and assuming no other income, I withdraw 39,000 dollars. I take the standard 8,450 dollars deduction. That drops my taxable income into the 15% bracket.

    I just turned 24, and for 2006, I put 15,000 dollars into my 401(k) and 4,000 dollars into my Roth IRA. I plan to do the same for 2007 and then some. That's why I'm looking into this.

    When comparing 2 options that are completely opposite, the optimal choice always contains elements from both extremes.

    By Anonymous Anonymous, at 12:54 AM  

  • I think one important intangible is this: discipline. If the after-tax contributions are going into a 401K it is more of a forced savings that you don't consider accessible to you. All these other scenerios assume someone is disciplined enough to invest the after-tax money somewhere and not blow through it.

    By Anonymous Anonymous, at 2:18 PM  

  • It would also depend on your investments in the after-tax accounts. For example, investing in REITs or bond funds would allow you to potentially gain as the returns from those funds are normally taxed at ordinary income tax rates. Postponing taxation on these accounts for 20-30 years would allow for tax-free compounding. Of course, you may end up in higher tax bracket by then, but thats the risk worth taking (in my opinion).

    By Anonymous Anonymous, at 6:08 PM  

  • Very helpful and interesting discussion. I agree that there are many scenarios in which after-tax 401(k) contributions aren't the best option.

    On the other hand, the point about capital gains tax rates can easily be overstated because, as someone has already pointed out, the CG rate is lower TODAY but may not be in the future. (And really, is it even LIKELY that it will be?)

    To the question as to whether 401(k) after-tax contributions even really exist, it's referenced in roundabout fashion in IRS Pub 560: "Participants may be permitted to make nondeductible contributions to a plan in addition to your contributions. Even though these employee contributions are not deductible, the earnings on them are tax free until distributed in later years." (See: Employee Contributions.)

    Not all employers allow after-tax contributions. Where they are allowed, they're subject to the total contribution cap of $42,000 per year (which spans all qualified retirement plans when applicable).

    By Blogger Jamie Samans, the Spontaneous Tourist, at 12:01 AM  

  • Thank you all for the information. I think they are all very useful.
    I try to send the question to Suze Orman but so far no response. Guess it's a complicate issue.

    Personnally I think I will stop contribute to a after tax 401k plan and switch to a Vanguard like fund.

    The way I look at this is that the the future income tax rate will very likely to increase considering the health care cost for the baby boomers and government spendings. Similarly to long term capital tax. I suspect the worse scenario is to be change to be the same as income tax rate.

    So I would consider the difference of the administrative cost will serve as insurance to be able to withdraw the money at any time for emergency, possibility of coming up ahead for future tax rates change, and less hassel with tax filing when you try to withdraw your 401k money, which is about 1.5% of your total portfolio (the percentage could be less if you have accumulated more money in your portfolio), which I think is worth while.

    Minou

    By Anonymous Anonymous, at 9:19 AM  

  • It seems to me a potential advantage of after tax 401(k) contributions is that this money can eventually be converted to a traditional IRA. Regular tax will be owed on earned income at the time of conversion, but the after tax 410K contributions will not be taxed. Then, this IRA money can be converted to a ROTH IRA. I believe that the taxable component of any money converted from a traditional IRA to a ROTH is based on the ratio of (TOTAL IRA pre-tax contributions+earnings)/TOTAL IRA holdings. If so, the after tax 401K contribution ultimately serves to raise the non-taxable IRA basis (in the same way a non-deductible IRA contribution does), and thus helps reduce the taxes on an IRA to ROTH IRA conversion. I'm not suggesting an after tax 401K is always the best thing to do from a tax perspective, but I believe it can be beneficial in some cases.

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