Ep 10: After-Tax 401(k) Contributions

Mike: [00:00:00] Welcome to financial planning for entrepreneurs and tech professionals. I'm your host, Mike Morton chartered financial counselor and financial advisor. And with me today is our great friend Julie, Julie, welcome back to the show.

Julie: [00:00:15] Thank you so much for having me. I really enjoy doing these.

Mike: [00:00:18] Today, we are talking about after tax 401k contributions, after tax contributions to your 401k account. Now this isn't going to apply to everybody out there. , it has to be part of your plan, your 401k plan at your employers. First I want to tell you what this is, why we're interested in doing it, and then we're going to get into some examples and really highlight why this is so cool.

401ks, we know these are employer tax, deferred accounts, traditional 401ks, many 401k plans have both a traditional and Roth side. So you, as the employee can now decide, Oh, do I want to make contributions to the traditional and take it off my taxes or to the Roth 401k and I'll pay taxes, but then it's in a tax-free

account right. Julie we've been over a traditional and Roth in multiple episodes. Now maybe the difference between those two.

Julie: [00:01:18] Although I've just learned that you, that they are separate, you can fund your own Roth. And then an additional one inside your 401k. Did I take that the right way?

Mike: [00:01:28] That's exactly right. Yeah. So 401k. That's right. Maybe we haven't talked about that too much, yet people. When they talk about 401ks, it's usually just traditional. So I'm taking it off my taxes. I can contribute $10,000 to my 401k and I saved $10,000 on my taxes.

And it's done automatically for you on your W2. So you don't even have to worry about it, some 401k is now offer a Roth 401k. So you can take that same 10,000 and contribute it to the Roth portion of the 401k and yeah, it's in a tax-free account now. You don't get the deduction now. You're going to pay taxes on it, just like your Roth IRA.

So maybe we haven't gone over that.

Julie: [00:02:04] No. And I'm curious, so this is information. How would you go about finding out what kind of 401k plan you have? I know you'd go through your HR, but they would, they know if the Roth and the traditional IRAs are part of the 401k plan or is that a blanket availability in every 401k

Mike: [00:02:25] No it's definitely not blanket. And yeah, you go to HR, but really it's going to be in your packet. Your benefits packet is going to have a one pager on the 401k and it will say in there very clearly. Do you want Roth or do you want traditional? And we'll talk about that. And also now we're getting into the after tax contributions.

That's another thing that will be in that benefits package is talking about. Oh, you're allowed to make after-tax contributions to your 401k.

Julie: [00:02:52] What you're saying is I have to actually read all that paperwork from HR.

Mike: [00:02:56] Yeah, no, you don't have to read all of it. Just the sections that you want to know about.

Julie: [00:03:02] Okay. So just to clarify here, because I'm, maybe I'm in the minority, but HR does not manage your 401k plan for you. They offer it, but then whatever happens within it is up to you.

Mike: [00:03:18] That's right. 401k plans are run by fiduciaries and institutions. So your company hires someone to run the plan. , HR knows all the details about, the what's and why's and how you can do things, and they've got the forms for you. And then you decide when you fill out those forms, how much you're contributing to what percent of your salary.

and then if you have the option, if it's going into the traditional side of the 401k or the Roth side of the 401k. Now, any employer matching. So anything that the employer puts in from profit sharing or matching will always be on the traditional side, not on the Roth. So only the employee has the option of putting money into the Roth 401k.

Julie: [00:04:01] this is something that you would bring to a financial planner. Am I right? So I was just thinking I wouldn't know where to begin with all of this stuff, which is why we hired somebody to help us with it. But that's, so you're giving us some information on this podcast, which is awesome.

But to get more information in depth in terms of how to navigate what your 401k looks like, where you can put your money, it might make sense to have a financial person. Look it over for you rather than asking HR.

Mike: [00:04:28] Yeah, HR is not going to give you kind of financial advice on what to do. They're just going to lay out what the possibilities are. Now. This is very similar to the question on, should I use a traditional IRA? Or a Roth IRA? Because we're putting money into a 401k and we have that same choice potentially at that same choice, you got to put it in a traditional 401k or the Roth side of my 401k.

So w you can go back and listen to that episode around, which is better for made Traditional or Roth. And do you want to pay taxes when your taxes are lowest. So you have to , I think about . Where's my income and my career. And so go back and listen to that episode around Traditional and Roth.

And that will give you some pointers into same thing for the 401k. Good questions.

. So we've got the 401k, you've got the employee contributions. We just talked about do Traditional or Roth potentially. Now you're limited to $19,500 as an employee contribution that's if you're under 50, over 50, you get extra $6,500 as a catch-up and then the employer can also put in money now that after tax, if you're allowed to do that, just briefly explain it is you're literally just doing that.

You're taking money that is in your checking or savings account. You've already paid taxes on it. It's sitting there and your brokerage or checking or saving, and you are going to add it to the 401k. So you could take maybe $10,000 and say, I'm going to take $10,000 for my savings account and add it to my 401k.

It's literally that easy. It's an after-tax 401k contribution. Now the immediate question is what, why would I do that? That's what we're going to get into today. Why would I do that? The reason quite simply instead of the money sitting in your taxable account, that $10,000, you can get it into a 401k where the taxes are deferred. And hopefully the real reason to do this is once you put it into the 401k, then you can roll it over to the Roth side. And now it's in a tax-free account forever. Okay, I'm going to talk about how that works, but let me give you a quick example, because I like to always start with, why do we care about this topic?

So say I have the capability of adding to my 401k after tax contributions. So instead of 25,000 sitting in my checking account, that is, or, my brokerage it's earmarked for retirement. So I saved it into the total us stock market, $25,000. I'm going to put it into an index fund for retirement?

Instead if I had the capability, I could put the $25,000 after tax contribution in my 401k plan, I can roll the $25,000 from, it has to go in after tax contributions on the traditional side. Then you can immediately do an in-plant conversion of just that $25,000. Now it's in the Roth side of my 401k and it grows tax-free forever.

So just one time twenty-five thousand dollar. After tax contribution after 20 years could put more than $20,000 of additional tax savings in your pocket.

Julie: [00:07:20] Wow. And the reason it is tax-free forever is because you've already paid taxes on it. Because it was an after tax contribution.

Mike: [00:07:30] That's right. So let's go back just briefly want to mention our three different account types for taxes. All right. Just to set the stage we have taxable, and this is just your savings, checkings brokerage accounts. These accounts are taxed every year. Right interest dividends. You get those statements from your savings account.

Hey, you made a hundred dollars of interest, so you put it on your taxes, right? So those are called taxable accounts. Any capital gains or anything is paid every year. You have tax deferred accounts where you have not yet pay taxes. This is your traditional 401k for 403(b) traditional IRA. You put in the contributions, you take it off your taxes, it grows tax free, but you haven't paid taxes on it.

That's why it's called tax deferred. The third type is tax-free. These are your yup. Go ahead.

Julie: [00:08:18] the tax deferred, you do pay taxes on it, but it's, once you start taking the money from those accounts to pay for your living expenses in retirement.

Mike: [00:08:28] that's exactly right. And that's why it's got that word deferred. That's right. You're deferring the taxes until later. Exactly. And then finally tax-free because we've already paid taxes. But the money gets to grow tax-free and when we withdraw it to use it to spend it, it's also tax-free. Okay. So the difference between taxable and tax-free is that the taxable is getting taxed every year and the interest in dividends.

And when you sell things, you get capital gains, you're going to pay, whereas the Roth or the tax-free accounts and HSA has fall in here as well. Tax-free they grow tax-free. And then when you use it, it's tax-free as well. Okay. So those are three account types.

Julie: [00:09:09] Okay.

Mike: [00:09:10] All right.

Julie: [00:09:11] a no-brainer

Mike: [00:09:12] It seems like a no brainer.

Julie: [00:09:14] There's gotta be a catch or

Mike: [00:09:16] . No, it's a good question. The catch that you gotta use it for retirement.

It's going into a 401k plan. There's all kinds of plan rules. You're not going to be able to withdraw it, basically until you're retired, that's what it's for. So the rules around that, so you're locking it up. Where's the taxable your checking or savings. You can use that at any time. So it is money

that is for the future. Sure. So that's one, one sort of catch, you gotta be careful about, making sure you have money in the meantime, you have to make sure you can roll it in plan to the Roth side of the 401k and then it's in that Roth side forever.

Julie: [00:09:50] How do you get your company to offer it?

Mike: [00:09:53] Talk to your HR department and tell them you're very interested in having this be part of your 401k plan. So there's limits for companies and 401k plans. They become more difficult to administer. So lots of small businesses will not have access to these types of things. Typically I've seen them quite often in larger businesses and quite often larger businesses where they have high incomes.

So they have the capability for saving more money. So I'm thinking large tech companies and Microsoft has been doing this forever for their employees very automatically. It's been awesome. And so it's becoming, little more, but people really don't know about it.

Julie: [00:10:35] Yeah let's get to some numbers. I wanna. See a real world application of this.

Mike: [00:10:39] All right. Fantastic. So let's say we're a married couple making $300,000. Now just one spouse is working. That spouse is going to max out their traditional 401k at $19,500. All right. That's the max that you can put in as an employee to a 401k. So going to go ahead and do that and then say the company matches $10,000.

They're matching, some percentage or some profit sharing they put in 10,000. So now we're at saved $29,500. Now the employee, again, maybe they put it into the Roth side or the traditional side depends on your situation, where you want to do that. But the total saved is $29,500 between employee and employer.

Now in 401k plans, there is a cap. All right. It's called the 415 limit. It's $58,000. So between employees and employers, that's the total that can be put in there. If you've got a great employer, Julie, they might put in all $58,000 for you. That'd be all. Awesome.

Julie: [00:11:41] That would be spectacular. Sign me up for that company.

Mike: [00:11:45] Yeah. Okay. So if they do that as an employee, you couldn't put in any more money.

Cause it's between both 58,000. So in this example, there's $29,500 between the employee and employer. So if they allow it, you can put in that employee can put in another 28,500 as an after-tax contribution. And then immediately tell the plan sponsor. I'd like to, contribute this and write them a check and send it in.

And then you tell them, I would like to roll this over now in the roll over process between this is inside the 401k, it goes from just one side of the house to the other. And when you do that one big difference between we've talked about doing a conversion of IRAs traditional to Roth, and there's this whole tax problem.

If you haven't paid taxes on it yet, then you take this pro-rata and all kinds. It gets very complicated. In this one it is not complicated because you can earmark those dollars and just say these after tax dollars, I want to transfer them over. And so therefore you don't owe any additional taxes.

Julie: [00:12:53] And when you say you tell the plan manager that you want to do this could also be as simple as a click of a button in your own.

Mike: [00:13:03] in the portal, correct? Yep. Yeah. Obviously

Julie: [00:13:07] show up as a Roth

Mike: [00:13:08] Yes. So the way, let me just finish this example. Now answer that question. No, it's perfect. So at the end of this example, we're also going to do, both spouses contributing 6,000 to their IRAs as well. So we saved a total of $70,000. In a combination of tax free and tax deferred accounts, rather than having that $28,500 in a taxable account.

We've now got it into a tax-free account, compounding tax-free forever. So fantastic. And a lot of great savings. Now, how does this show up on your statements? So when you have a 401k plan with both traditional and Roth sides, you will get statements that show you how much money is in each of those.

So if you have $50,000 that saved in your 401k, it'll say $20,000 is pretax on the traditional and $30,000 is in the Roth and it'll show you that breakdown. So when you add these contributions and roll them over, it'll show up on those statements. Now, some plans allow you to control which investments.

are on which side, so you can say, Oh, my Roth side, I want to invest in XYZ. And the traditional side, I want to invest in these other things , you could do that. And it's a really good idea, but for individuals, it gets pretty complicated to pick well, which should be in Roth and which should be in traditional.

So maybe we'll have another podcast on which assets should be in which type of account, those three different types that we talked about. Where should you hold? Which types of investments.

Julie: [00:14:39] seems to be more in depth than what we're talking about here.

Mike: [00:14:46] With the after tax contributions today. All right. I'm going to give you a couple of other examples because I want to also get to a self-employed example, but let's say same couple. We're just working with the, now both of them are working. All right. So they, and they both have 401k plans, so they can both contribute $19,500 to their 401k's.

So both husband and wife can max out their employee contributions of $19,500 company matches 10,000, say both of their companies do that. So that's the same totals , $29,500 for each of them. Then they can each make that after-tax contribution. Same as a before 28,500 after tax into their 401ks.

They both do the IRAs. And now as a couple, you can save up to $128,000 into tax deferred and tax-free account. So significant can amount of money is able to be put away normally think, Oh, my 401k limit is 19,500. Maybe we got a couple of working people and they're putting it in there, but look how much we can get up to, into these tax deferred and tax free accounts.

If you have the capability of adding after tax contributions.

Julie: [00:15:54] It's significant. This is certainly a topic for higher earners.

Mike: [00:15:59] Yeah, absolutely. Now will mention, I'll mention this note too. Not only higher earners, but people that have significant taxable savings. Okay. So say you've already saved up a couple of hundred thousand into a brokerage account just over the years you've diligently saved, or maybe you had some inheritance or something, that you have money in a taxable account and it's sitting there and it's earmarked for retirement. I'm going up. It allows us to invest and grow for later. , just because you were spending your income for the most part. Oh, look I'm able to save 20,000. I can get, I can max out the 401k contribution.

Maybe I can do the IRA, but I'm pretty much spending, the rest of my salary. As long as you have the salary and that's an important point. , these savings have to be from salary. Okay. So you have to make at least 128,000 to be able to save it into these accounts. But as long as you have that income, even if you're spending it in your just day-to-day living, you could still transfer after tax contributions from , your brokerage account over to your 401k.

So it's not necessarily oh, I don't have the money this year, from my income. If you have that taxable savings, this is a way of shoving it into, better accounts for less tax payments.

Julie: [00:17:16] Yeah, for sure. Okay. Thanks for the clarification.

Mike: [00:17:20] Yeah, definitely. Okay. And then one last example is the self-employed because this is.

Where you can turbocharge a lot of this stuff as well. So say we have one person who has both working for a company, but also as a side hustle, has a business or something else on the side. So you can max out your 401k contributions to your employer. $19,500 and the company matches 10,000.

So you still get 29 five you could do after tax contributions. 28, five still is same as before. But if you have a side business where you're making say $75,000, that business could open a solo 401k, and you can't contribute as an employee because you're max out at 19,500, no matter how many 401ks you have.

So you can split it up and say, I'll do something to this 401k and some of this other one, but you can't do more than 19 five total across all your 401ks, but you can do after tax contributions. So you could put in another $58,000 as after tax contributions, or maybe that self-employment in the 401k of profit sharing.

So maybe the employer is putting in some, and then you can bump up the rest with after tax, roll it over to the Roth. And so you can still save over $120,000, even as a single self-employed, if you have access to a couple of these employer plans. So again, yeah,

Julie: [00:18:47] sorry, just to

Mike: [00:18:48] no. Yeah.

Julie: [00:18:49] So as a self-employed, so in your example of the side hustle, right? The person could not take the money from the side business and deposited into the 401k of their normal nine to five. They would have to open a separate 401k under the business name of whatever their company is and do it that way.

Mike: [00:19:13] you can do both. So you can contribute if you're getting salary from your employer of 150,000 from your nine to five job you can put in the employee contributions, they do some matching, then you can do after tax contributions up to that $58,000 cap

on that, just to that,

Julie: [00:19:33] matter if the money came from your nine to five or,

you

Mike: [00:19:37] Yeah, where the actual dollars come from doesn't matter. But again, you have to have the income. So if you only in your self employed a business, let's take the reverse. So you're making 150 at your 401k. I mean your employer's business and you do that and max it out 58,000, say on your side hustle, you made $20,000.

Then you can't contribute more than 20,000 on that side because your income from that business was only 20,000. So you could do after tax contributions of 20,000, but not more than that.

Julie: [00:20:10] So if you're, so what you're saying is if your income was 20,000, you pay taxes on that 20001st, and whatever's leftover, you can put into the 401k and then roll it over to the Roth.

Mike: [00:20:21] Yeah. Yup. Exactly. Yeah. Now you, if you're, if it's that low, you might do other things. This is really strategies. Once you get above, making more. So in that case, you could do the 19 five as the employee contribution, or there might be other ways of structuring it, depending on how much you're making.

. But that's important point, having, you have to have the income. The other thing to mention is that required minimum distributions. Once you reached the age of 72, you are required to take distributions from 401ks.

It doesn't matter if they're traditional or Roth. . The Roth. You're not going to pay taxes on that, but we'd rather leave the money in there if you didn't need it that year, that you turned 72. So the way to do that is to roll the 401k Roth balance into a Roth IRA. And you can do that again. The 401k plan sponsor, you let them know.

I want to take this 300,000 that's in the Roth side, I have 200,000 in traditional and 300 in the Roth. I'd like to roll the 300 into my own Roth IRA because Roth IRAs do not have minimum distributions. Does that make sense?

Julie: [00:21:26] no, because they're both Roth IRAs.

Mike: [00:21:29] No. Is a Roth 401k. So this is in, this is the 401k

Julie: [00:21:33] they are, they're actually labeled separate. There is a, for a Roth 401k and then our

regular Roth.

Mike: [00:21:43] Roth IRA.

Julie: [00:21:44] to say traditional because there's a traditional IRA and then a

Mike: [00:21:47] Yeah. The traditional with the capital T or the small T that's, the normal. So yeah, this is all within what we're talking about today is all within a 401k. It's all within your employer's 401k. And you can think of it as two halves. There's a traditional side of the 401k and the Roth side of the 401k, but it's all lumped together.

$150,000 there. And typically you're not looking at the breakdown, which is on which half it's just, Oh, I've got 150,000 saved. Some of it's Roth, some of it's traditional. Okay. Now you can dive into that. Like I said, when you get your statements, you can see, Oh yeah. 50,000 is on the Roth side, a hundred thousands on the traditional side, but it's usually lumped together at the very top of that piece of paper.

Julie: [00:22:30] so let's just go back to that one example you just gave because , isn't there a max contribution to a Roth every year.

Mike: [00:22:37] So it's funny. There's, we're applying two different words and two different account types. There's traditional and Roth. We know what the difference there is. There's 401ks and IRAs. Okay. The difference there is the 401k is an employer plan and an individual retirement account.

As an individual plan, both traditional Roth can be applied to both 401k and IRA.

Julie: [00:23:01] correct. So my, my question is there's a limit to which you can contribute to a Roth IRA per year, right? Isn't it about $6,000 or something.

Mike: [00:23:12] correct. There's a limit to how much you can contribute to a Roth IRA. In fact, it is contributions to IRAs is limited to $6,000, whether it's traditional Roth or a combination it's $6,000 total. Now 401k has different limits. The 401k limit is 19,500, whether you do some in traditional some in Roth, or combination it's 19,500.

Julie: [00:23:38] right. But then you can add in up to 28, five or what have

Mike: [00:23:44] You can add in up to you up to the 58,000. I was making the employer do about 10,000, but the total would be 58,000 across all contributions.

Julie: [00:23:53] hall. So in the example you gave where you roll over the 300,000, that was in the 401k Roth. And I see where I'm going with this. You said I want to roll it over to a traditional Roth. Isn't you can't because you're only allowed 6,000 per year.

Mike: [00:24:08] This is rolling over, not contributing. You are not making contributions from your income or taxable accounts. You're literally just rolling over and the rolling over means I'm just transferring it. And the reason you're allowed to do it, Julie is because you're transferring from a Roth 401k.

When we know how that works, tax-free forever into a Roth IRA. Oh. Which is the exact same tax-free forever. So the government says, yes, you're allowed to do that because we're not losing out on any of our taxes. So as much as you want to roll from your Roth, 401k into your own Roth IRA, you're allowed to do that.

No problem, because it's all the same to you now. Difference though that I highlighted is that the 401k plan documents will make you take required minimum distributions, and they don't care where it comes from. They're saying you just have to take it. So we want to get that into the IRA because the IRA doesn't have that.

Julie: [00:25:03] Got it. I'm a hundred percent clear. Thank

Mike: [00:25:05] Yeah. Super cool. , we covered a lot today.

Account types. Here's the important thing. If your plan document allows you to make after-tax contributions to your 401k and do in plan Roth conversions. You want to look at that? I could have said that right at the top.

Julie: [00:25:28] probably should have led with that one way to bury the lead.

Mike: [00:25:31] But that's what you want to do. And then you can start figuring out these details and seeing how much money you're going to save over time. It's fantastic. All right. Thanks Julie. Another good one and we'll see you next time.

Julie: [00:25:42] All right. So yeah.

Mike: [00:25:43] Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at . Until next time thanks for tuning in