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However, the reason after tax contributions to a 401(k) aren't ideal is that any proceeds withdrawn at retirement are taxed at ordinary income rates.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