What is After-Tax Contribution?
After-tax contribution refers to the monetary contribution made to retirement systems after deducting taxes from the individual’s or corporation’s taxable income.
After-tax contributions are extremely popular for investments, as they allow withdrawals made after retirement to be non-taxable since the tax’s already been paid previously. Understanding the entire process of after-tax contribution can be quite tricky since it requires good knowledge of the taxation process.
- After-tax contribution refers to the monetary contribution made to retirement systems after deducting taxes from the individual’s or corporation’s taxable income.
- In the U.S., there are two main types of after-tax contributions – the traditional after-tax contribution and the Roth 401(k) after-tax contribution.
- For the traditional after-tax contribution, the original contribution is not taxed (it has already been taxed before being placed in the retirement plan) but the earnings are taxed upon withdrawal.
- The Roth 401(k) after-tax contribution is offered by some employers – both the original contribution and the earnings are not taxable when it is withdrawn after retirement.
The Basics of Contribution: Pre-Tax and After-Tax
Contributions to retirement plans, in general, can be made under two scenarios: before-tax and after-tax. As mentioned previously, after-tax contribution is more popular with investors since they prefer not to pay taxes on the withdrawals that they make from the plan at a later date. The after-tax contribution is likely more beneficial if the tax rate rises in the future.
Pre-tax contributions (contributions made without paying taxes previously) means that unlike after-tax contributions, the individual or corporation needs to pay taxes when they withdraw amounts from the retirement plan.
How Does After-Tax Contribution Work?
Retirements plans using after-tax contributions consist of two main items – the original after-tax contribution amount made by the individual and tax-deferred earnings made on the contribution. When the individual withdraws money from the plan, the after-tax contribution is not taxed, but the tax-deferred earnings are taxed at the time of the withdrawal.
In the U.S., there are two main types of programs with regards to after-tax contributions – the traditional after-tax contributions and Roth 401(k) after-tax contributions.
Roth 401(k) After-Tax Contribution
Roth 401(k) contributions are sometimes offered by employers through employees’ retirement accounts. It is optional, and individual employees will choose a method that will offer them the most savings opportunities.
Similar to the traditional after-tax contributions, Roth 401(k) contributions are subject to tax before the remainder is put into retirement plans, where the contribution grows until it is taken out after retirement. What is unique about the Roth 401(k) is that when taken out, both the original contributions and the earnings made are entirely tax-free.
The practice is in contrast with traditional after-tax contributions, as explained above, where the earnings are still taxable at the withdrawal date even though the original contribution is tax-free. As such, it can be highly desirable for some individuals.
|"Regular' After-Tax Contributions||Roth 401(k) Contributions|
|Original Contribution||Not taxed||Not taxed|
Pros and Cons of After-Tax Contribution
One of the main advantages of after-tax contributions is that individuals don’t need to pay taxes on the contributions when they withdraw from the retirement plan after retirement – as opposed to pre-tax contributions, which are taxable later on.
One key disadvantage of after-tax contributions is that its complexity – with funds being separated into different components – makes it much more difficult to figure out the amount of tax that needs to be paid.
On the other hand, if the individual only made pre-tax contributions in the past, it would be much simpler, as it means the taxable amount would be calculated easily.
CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: