401k: After-tax vs. Designated Roth Account

Total Wealth: Financial Capital & Human Capital
September 27, 2017
Florida Prepaid Open Enrollment
October 16, 2017
Orange autumn trees seen from the forest floor against a blue sky.

Some confusion remains about the difference between after-tax contributions to a 401k plan and contributions made to a Designated Roth Account within a 401k plan. With any luck, we can clear some of this up.

The plain vanilla 401k plan permits participant employees to make pre-tax elective deferrals (contributions) into their account. Taxes on the income used to fund these contributions, and any subsequent growth, are deferred until the assets are eventually distributed to the participant, or the participant’s beneficiary.

Although it is not always the case, some plans permit two other types of contributions: after-tax contributions and contributions to a Designated Roth Account.

What Are After-tax Contributions to a 401k Plan?

Not surprisingly, after-tax contributions are contributions made by participants of a 401k plan on an after-tax basis. What might be surprising, is that these contributions are actually made to the same account as traditional pre-tax contributions. Earnings on after-tax contributions grow tax-deferred, just like earnings on traditional 401k contributions.

Not all plans permit this type of contribution. In fact, it seems that relatively few plans support after-tax contributions. Those that do, provide an amazing vehicle for some extreme retirement saving.

The maximum elective deferral that a participant under the age of 50 can make in 2017 is $18,000 ($24,000 over age 50). This is a healthy annual retirement plan contribution for most. For some, though, there is room for additional saving.

Plan permitting, after-tax contributions can be made up to the overall limit on 401k plan contributions for 2017 of $54,000 ($60,000 for those over age 50). The difference between the overall limit and the maximum elective deferral obviously represents a wide margin, and an attractive opportunity to squirrel away additional retirement dollars.

The basic calculation for the maximum amount of after-tax contributions – when permitted – is the applicable overall contribution limit, minus the sum of employee elective deferrals, employer matching contributions, and employer discretionary deferrals.

What are the Benefits of After-tax 401k Plan Contributions?

Some might balk at the idea of contributions made to a 401k plan that don’t result in the present reduction of taxes, or the tax-free growth of earnings. Some might be right to balk. Those that have the additional assets to contribute, however, might want to consider some of the delayed benefits.

No, after-tax contributions do not reduce taxable income.

Yes, earnings on after-tax contributions grow tax-deferred, and not tax-free.

Yes, after-tax contributions can eventually be rolled over into a Roth IRA, where any subsequent earnings will grow tax-free…Wait…What?!

That’s right! After-tax contributions can eventually be utilized to super charge one’s Roth IRA. This is not the place to extol the benefits of the Roth IRA, but they are many.

At first blush, this seems like something that would exist in the grey areas of asset management. Some will be surprised to know that not only is this totally above board, but, back in 2014, the IRS made the process of getting after-tax contributions into a Roth IRA even easier. The details can be found in IRS Notice 2014-54.

Essentially, the primary benefit of making after-tax contributions rests in the idea that assets that ever have an opportunity to grow tax-free are beneficial. Because contributions to Roth IRAs and Dedicated Roth Accounts are comparatively  limited, after-tax contributions provide a means to further fatten up one’s future Roth balances.

Although some 401k plans do permit in-plan conversions of after-tax contributions into the plan’s Designated Roth Account (with taxes being due on any earnings associated with the after-tax contributions), getting assets converted from after-tax contributions into a Roth IRA usually requires a qualifying event. These events include separation from service, the achievement of age 59 ½, and a couple of others.

When a qualifying event occurs, the amount contributed on an after-tax basis can be rolled into a Roth IRA. Any earnings on the contributions can be rolled into a pre-tax account, such as a Traditional IRA or another retirement plan (plan permitting). Once the after-tax contributions are in a Roth IRA, they are treated as any other Roth IRA contributions.

What Is a 401k Designated Roth Account?

First implemented in 2006, a Designated Roth Account within a 401k plan is a separately maintained account into which a participant can make after-tax designated Roth contributions.

Contributions to a Designated Roth Account can be made up to the elective deferral limit of $18,000 ($24,000 over age 50) in 2017. This limit is in combination with, as opposed to in addition to, any pre-tax contributions made to a 401k plan.

Interestingly, employer contributions cannot be made to the Roth account, so any employer matches to employee Roth account contributions are made to a separate pre-tax account.

The Roth name is a little tricky here. In general, the primary assumptions based on the name would be correct. These contributions are made on an after-tax basis and grow tax-free, just like a Roth IRA. However, because of the 401k wrapper, the similarities get a little blurry beyond that.

Similar to a Roth IRA, contributions from a Designated Roth Account can technically be distributed at any time without tax consequences. The kicker here is that any nonqualified distributions must be distributed on a pro-rata basis. This means that, if there are any earnings in the account, contributions cannot be singled out for distribution. The earnings that must accompany contributions in the event of a nonqualified distribution will be taxed and penalized.

Another quirk of the Designated Roth Account is that, unlike the Roth IRA, Required Minimum Distributions may apply to the assets at some point. Luckily, being forced to take the distributions can be easily enough avoided by rolling the Designated Roth Account assets into a Roth IRA.

The Big Roth 401k to Roth IRA Question

A commonly recurring question is whether or not a rollover from a Designated Roth Account into a Roth IRA is treated uniformly as a contribution to that Roth IRA. The answer is no.

A rollover from a Designated Roth Account into a Roth IRA is completed as its components. The contributions into the Designated Roth Account come over to the Roth IRA as contributions, and the earnings come over as earnings.

The reason that this question is asked so frequently is because it would be an incredible boon for savers if both the contributions and earnings of a Designated Roth Account could be transferred to a Roth IRA, viewed as a single contribution, and, therefore, become entirely eligible for nonqualified distributions without tax or penalty. Again, this is not the case. Only the contribution component would be eligible for tax and penalty free nonqualified distributions.

After-tax or Designated Roth Account Contributions?

It is easy to draw similarities between the ultimate benefits of after-tax and Designated Roth Account contributions to a 401k plan; but this isn’t really an either-or question. If the benefits of Rothish attributes are the goal, and a Roth account is available within a 401k plan, then the Designated Roth Account still provides the purest Roth exposure.

It seems that the greatest benefit of after-tax contributions is that they provide the opportunity to contribute above and beyond Roth contributions, or in addition to (or, conceivably, instead of) traditional pre-tax contributions. If this is true, then after-tax contributions are more of a bonus than an alternative.

The important thing to realize is that after-tax contributions and contributions to a Designated Roth Account are very different things. Contributions to a Designated Roth Account are, indeed, contributions made on an after-tax basis, but after-tax contributions to a 401k are not contributions to a Designated Roth Account. In this case, the distinction matters.

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