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An after-tax contribution is a kind of retirement investment made with money that has already paid taxes. Unlike pre-tax contributions, like those made to a 401(k) or traditional IRA, after-tax contributions do not lower your taxable income in the year you make them. They do, however, have some benefits that might appeal to some investors.
One of the key advantages of after-tax contributions is their ability to grow tax-free in a Roth account. If you meet certain requirements, a Roth account is a form of retirement plan that enables you to take tax-free distributions of your earnings and contributions in retirement. The after-tax contributions you make to a Roth IRA can be converted to a Roth account through a procedure known as a Roth conversion, as well as the after-tax contributions you make to a 401(k) or other plan.
Increasing your overall retirement savings limit is another advantage of after-tax contributions. The amount you can contribute each year to various kinds of retirement plans is capped by the IRS. For instance, in 2023, you are permitted to make 401(k) plan contributions of up to $20,500 and IRA contributions of up to $6,000 (or $7,000 if you are 50 or older). However, only pre-tax and Roth donations are subject to these caps. To some plans, like a 401(k), you can also contribute after-tax money up to a greater cap of $61,000 (or $66,000 if you're 50 or older). This means that by adding after-tax contributions to your pre-tax or Roth contributions, you may be able to save more money for retirement.
Nonetheless, there are several disadvantages and difficulties associated with making after-tax payments. One of them is that if you take money out of a non-Roth account, you might have to pay taxes on it. Required Minimum Distributions (RMDs), which are obligatory withdrawals from your account that you must begin taking when you turn 72, are not applicable to Roth accounts, only non-Roth accounts. These withdrawals are subject to ordinary income tax, which could lower your retirement after-tax income.
Another difficulty with after-tax contribution is that if you have both pre-tax and after-tax money in the same account, they can be subject to the pro-rata rule. According to the pro-rata rule, when you convert or remove money from an account that contains both sorts of funds, you must treat it as a proportional mix of both. You must treat a $10,000 withdrawal or conversion as $8,000 in pre-tax funds and $2,000 in after-tax funds, for instance if your account includes 80% pre-tax funds and 20% after-tax funds. This implies that you are unable to opt to withdraw or convert solely your after-tax funds in order to avoid paying taxes on your pre-tax funds.
As a result, you should think about your objectives, tax situation, and available solutions before making after-tax contributions. For assistance in determining if after-tax contributions are appropriate for you and how to optimize your retirement savings strategy, you should also speak with a tax expert or financial planner.
