Legit Money Laundering: After-Tax 401k Contributions
Are we really talking about money laundering in a financial advice podcast? Yes, but it is completely legit and could give you an extra $25k/year! This week Matt and I explored a unique and powerful strategy for maximizing savings and potential earnings: After-Tax 401k contributions. The short story involves using your taxable brokerage account for living expenses and contributing your maximum amount to an often overlooked employee benefit: after-tax 401k’s.
Does this strategy apply to you?
Let’s break it down with the long story. First, who does this strategy even apply to?
- Anyone with access to make after-tax 401k contributions as an employee benefit or people not maximizing their contributions to the pre-tax 401k (check with human resources to find out if you are offered this benefit) AND
- Anyone with long-term investments in a brokerage account
Now that we’ve established the ‘who,’ let’s look at the what:
But I can’t save more money!
The ‘money laundering’ strategy involves transferring funds from a taxable brokerage account into a 401k, but it’s not a direct transfer because that isn’t permitted. In order to make contributions to a 401k (pre-tax, post-tax or after-tax), the money must come directly from your paycheck. But Mike, if I am transferring even more money from my paycheck into my 401k’s, how will I pay my mortgage and feed my kids? Good question. Here’s where the laundering happens.
Refer back to number two in the above “who” guidelines. That money sitting in the brokerage account gets transferred to your checking account for you to spend on your everyday life. The goal is to bridge the gap between contributions to the 401k and general budgeting, allowing for the full after-tax contributions to be made.
Why bother with all these transfers?
Why bother with this? Won’t you have to pay capital gains on the money taken out of your brokerage account? The answer is yes, but the benefit far outweighs the tax.
Let’s take a look at the following chart to see the difference between that money staying in your brokerage account or growing tax-free as after-tax 401(k) contributions. Using the following assumptions, it is clear that choosing the right account type makes a significant impact on your overall savings.
- Compounding Growth: 6% Growth + 2% Dividends (8% total)
- Income Tax Bracket: 24%
- Capital Gains Tax Bracket: 15%
|Value (After Tax)
|Value (After Tax
Let’s talk specifics: How to implement this strategy
While this might seem overly complicated, it only involves some adjustments at the beginning of the year to achieve this goal. So, how do you make this strategy work for you?
- At the beginning of the year, make adjustments from your employee portal to add/increase your contributions to 401k and after-tax 401k from your paycheck.
- Ensure that your after-tax 401k contributions are being rolled into the Roth “side” of your 401k
- Set an auto-transfer from your brokerage account to your checking account in the amount you would have received in your paycheck.
- Live your life and watch your money start working smarter for you.
What if you don’t have access to after-tax 401k contributions?
Bummed that you don’t have an after-tax 401k at your place of employment? This strategy can also be used with 529s, HSAs, and IRAs. The key takeaway: tax-free growth versus taxable growth. After-tax 401k, 529, HSAs and IRAs all grow tax-free whereas your brokerage gets taxed every single year. That yearly tax slows down your compounding growth!
Wouldn’t it be cool watercooler fodder to say your money laundering has earned you an extra $25k? Tune in to this podcast to learn all about this strategy in order to optimize your savings and investments. By strategically utilizing after-tax 401k contributions, you can unlock additional earnings and set yourself on a path to financial success. The key lies in understanding the process, assessing your circumstances, and seizing the opportunity to make your money work smarter and harder.