After Tax Contribution vs Taxable Account

[justlearning]

My company offers "saving plan" for retirement where i can contribute up to $18500 pre-tax for this year which is clear to me. It also has option to put after tax money up to 6%. I am reading the "Savings Plan Summary Plan Description" for the after tax contribution it says;

"You may save an additional 1% to 6% of your after-tax pay each pay period in whole increments. Aftertax contributions are deducted from your pay by the Company after federal, state and local income taxes and FICA taxes are withheld. After-tax contributions may be taken from the first $270,000 of pay in
2017. This pay limit may be increased for inflation in years after 2017. While you do not receive a Company matching contribution on after-tax contributions – nor do you gain all the federal income tax advantages available through before-tax savings – your after-tax contributions share in the investment results of the Plan and grow on a tax-deferred basis."

if i am understanding the after tax portion correctly. It basically works like taxable investment account right?

is there any benefit for me contribute to after tax plan my company offers? or should i just open normal taxable account from Vanguard or Fidelity and put money in there as they offer more low cost investment options?

Thank you.

[jessikaur]

actually, if I'm reading what you wrote correctly, it's better than taxable because all of the growth is tax deferred... so it works like a roth (using after tax money) but the growth is deferred like a regular IRA or 401k until you take it out.

 

taxable is after tax money, but taxed on the dividends as your ordinary income, and then taxed at capital gains rates when you take out.

If you do not have liquidity issues (i.e that you think you might use the money before retirement), I would totally contribute to after tax as long as the investments that are available are good with your employer, it's like half of a free ride...

if you think you might need the cash for a big purchase like a house etc then i would put it in the taxable.

[jfoxcpacfp]

After tax does not work like a taxable investment account. Unless your plan allows you to roll over your after-tax contributions into a Roth IRA, I would recommend a taxable account before an after-tax account. The reason is that, while your AT investments may grow tax-deferred, when you liquidate or convert to a Roth IRA, you will pay taxes on all of the growth at your top marginal income tax rate. In a taxable account, your investments are growing tax deferred (i.e. not taxed until you sell or receive dividends and capital gains distributions) and you will be taxed at the more favorable LTCG and dividends rates when you sell.

If you have the option to convert to a Roth periodically (say quarterly or annually), you will pay tax on minimal growth and start the tax-free growth at the point of conversion. Your plan should offer this option, but I don't see the language for it above. If you cannot convert, you are in the worst possible place - investment growth on which you are paying top rates.

Another point to consider is that your heirs can inherit your taxable account and get a stepped-up basis. If they inherit your AT account, they will pay taxes on all of the growth beyond your "basis" (your original contributions).

[justlearning]

jfoxcpacfp wrote:

After tax does not work like a taxable investment account. Unless your plan allows you to roll over your after-tax contributions into a Roth IRA, I would recommend a taxable account before an after-tax account. The reason is that, while your AT investments may grow tax-deferred, when you liquidate or convert to a Roth IRA, you will pay taxes on all of the growth at your top marginal income tax rate. In a taxable account, your investments are growing tax deferred (i.e. not taxed until you sell or receive dividends and capital gains distributions) and you will be taxed at the more favorable LTCG and dividends rates when you sell.

If you have the option to convert to a Roth periodically (say quarterly or annually), you will pay tax on minimal growth and start the tax-free growth at the point of conversion. Your plan should offer this option, but I don’t see the language for it above. If you cannot convert, you are in the worst possible place – investment growth on which you are paying top rates.

Another point to consider is that your heirs can inherit your taxable account and get a stepped-up basis. If they inherit your AT account, they will pay taxes on all of the growth beyond your “basis” (your original contributions).

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Thank you Johanna. I review the plan document again. In the rollovers section it looks like i can convert to Roth IRA. Here is the language in the plan

"You may generally roll over all or part of any distribution you receive from the Plan into an “eligible retirement plan” that accepts rollovers. For this purpose, an “eligible retirement plan” includes:
An individual retirement account described in section 408(a) of the Internal Revenue Code,
An individual retirement annuity described in section 408(b) of the Internal Revenue Code (other than an endowment contract),
An annuity plan described in section 403(a) of the Internal Revenue Code,
A qualified retirement plan described in section 401(a) of the Internal Revenue Code,
An eligible deferred compensation plan described in section 457 of the Internal Revenue Code,
An annuity contract described in section 403(b) of the Internal Revenue Code, or
A Roth individual retirement account described in section 408A of the Code.

After-tax contributions, however, can only be rolled over to an individual retirement account or annuity (other than an endowment contract) described in section 408(a) or 408(b) of the Internal Revenue Code, an annuity plan described in section 403(a) of the Internal Revenue Code, a qualified retirement plan
described in section 401(a) of the Internal Revenue Code or a Roth individual retirement account described in section 408A of the Code. After-tax contributions must be directly rolled over to the eligible retirement plan and the eligible retirement plan must separately track the after-tax contribution"

so i should continue to contribute it and convert to Roth every year or so.

 

 

 

[ENT Doc]

This is the mega backdoor Roth concept. Put after tax money in, rollover to Roth and you now have more money in the Roth space than you would have otherwise. Here's my question with this, and it relates to a concept posted above:

My brother's employer, through some arm-twisting by T Rowe Price, has limited the rollover to once a year. Apparently some employee was doing the smart thing and rolling over every month which annoyed TRP who then contacted the employer who put out a memo saying employees could only do this once a year. Aside from the shifty (and possibly illegal ? behavior here), what should he do? At what point does one say I want to stop funding the after tax bucket so I can get as much of the contributions and their growth into the Roth space vs contributing to the max after tax space over multiple pay periods (to get a larger Roth rollover) but forgoing some of the (presumed) growth along the way? No employer match so lots of space to fill. The longer you wait the more it (presumably) becomes a hybrid Roth/Pre-tax decision. The shorter you wait the more it's just a Roth but at a lower total. Thoughts?

[jfoxcpacfp]

justlearning wrote:

so i should continue to contribute it and convert to Roth every year or so.

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Yes, absolutely. You have been handed a gift. The NRAT (Non-Roth After Tax) contribution is not limited by percentages of income. Even though your employer has defined the amount that can be deducted from your paycheck in terms of %s, that is for the employer’s convenience (I suspect) not because you have a real limit. Iow, if you contribute $18500 and your employer matches $11,500, you can add an additional $25,000 via the NRAT. Great way to build up the Roth allocation in your retirement portfolio.

[jfoxcpacfp]

ENT Doc wrote:

This is the mega backdoor Roth concept. Put after tax money in, rollover to Roth and you now have more money in the Roth space than you would have otherwise. Here’s my question with this, and it relates to a concept posted above:

My brother’s employer, through some arm-twisting by T Rowe Price, has limited the rollover to once a year. Apparently some employee was doing the smart thing and rolling over every month which annoyed TRP who then contacted the employer who put out a memo saying employees could only do this once a year. Aside from the shifty (and possibly illegal ? behavior here), what should he do? At what point does one say I want to stop funding the after tax bucket so I can get as much of the contributions and their growth into the Roth space vs contributing to the max after tax space over multiple pay periods (to get a larger Roth rollover) but forgoing some of the (presumed) growth along the way? No employer match so lots of space to fill. The longer you wait the more it (presumably) becomes a hybrid Roth/Pre-tax decision. The shorter you wait the more it’s just a Roth but at a lower total. Thoughts?

Click to expand...

I don’t see anything shifty or illegal here. It places a burden on the accounting department and the custodian to manage Roth conversions. I am surprised that they allowed unlimited conversions in the first place. I’ve seen quarterly and annually and, if I were the employer, would probably go with annually. He still has a tremendous opportunity so I’d say make hay while the sun shines and be thankful that he has the NRAT opportunity, in whatever shape. Max it out!

[ENT Doc]

Really? You'd still max it out even though the earnings will produce the worst taxed type of account additions? It's not like you get the benefit of tax reduction in the present - you get taxed on the margin and then have to pay tax at whatever marginal rate those contributions' earnings are in X years down the road.

[jfoxcpacfp]

ENT Doc wrote:

Really? You’d still max it out even though the earnings will produce the worst taxed type of account additions? It’s not like you get the benefit of tax reduction in the present – you get taxed on the margin and then have to pay tax at whatever marginal rate those contributions’ earnings are in X years down the road.

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Sure! Now that @justlearning has clarified that this is the Mega Backdoor Roth, why not? As I said in my first response, if there were no opportunity to convert, I would agree with you and favor a taxable over a nondeductible IRA (basically what was first described). A nondeductible IRA is the absolute worst way to save for retirement. But now that we know s/he can convert to a Roth, the answer changes to “max it out”.

So you would prefer a taxable account to a Roth IRA?

[ENT Doc]

But there's a time factor here. If you can convert immediately the money looks more like (and is) a Roth account. If you wait until infinity to convert then the more that contribution looks like a non-deductible IRA. In the middle of these two, from a tax efficiency perspective, is a taxable account. So the question becomes when you should do the after-tax conversion. It may be that less than a year makes it more tax efficient than a taxable account, but I haven't seen or done the math to confirm this. It's not a decision between Roth and taxable when you are forced to wait to do the conversion. It's a choice between hybrid Roth/non-deductible IRA and taxable.

[jfoxcpacfp]

ENT Doc wrote:

But there’s a time factor here. If you can convert immediately the money looks more like (and is) a Roth account. If you wait until infinity to convert then the more that contribution looks like a non-deductible IRA. In the middle of these two, from a tax efficiency perspective, is a taxable account. So the question becomes when you should do the after-tax conversion. It may be that less than a year makes it more tax efficient than a taxable account, but I haven’t seen or done the math to confirm this. It’s not a decision between Roth and taxable when you are forced to wait to do the conversion. It’s a choice between hybrid Roth/non-deductible IRA and taxable.

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I didn't see any requirement to wait until infinity or even a year. You are changing the original topic and dithering about a "time factor". (Even if the OP did have to wait a year, I would prefer the MBR to a taxable, but that doesn't appear to be the case here.) Just asking again, do you think a taxable account is preferable to a Mega Backdoor Roth and is that what you would advise the OP? If so, we'll just have to agree to disagree.

[StarTrekDoc]

If limited to once a year because of custodial constraints -- wouldn't ideal be max out ASAP and convert/distribute/rollover to the Roth that once a year?

It would be interesting if TRP actually has a counter showing how many has occurred over the year and would stop a distribution.

 

[ENT Doc]

I agreee, but maxing it out ASAP typically means having contributions sitting there for upwards of 8 months (assuming no employer contribution and doing this before or after you've completely done your pre-tax contributions). This is the time factor I mentioned. If you are doing your pre-tax and after-tax contributions simultaneously every month you're waiting upwards of a year to roll some of the after-tax amounts over, which creates earnings at 12, 11, 10, etc. months that are taxed in the worst possible way. If you are only able to roll over once a year, and if you are contributing on a monthly basis, you have to accept that in order to have more Roth money you have to create, via earnings prior to rollover, money taxed at ordinary income.

[ENT Doc]

Johanna by "waiting a year" I mean waiting a year on the first contribution, assuming they are made monthly in equal amounts. Of course you want more Roth money than taxable, but again you don't get to just have Roth money. By nature of being retricted to a once-a-year rollover (as I described in my sibling's scenario) or having to wait until all 12 contributions are made (that the OP alluded to in their last comment) you have to accept that with your additional Roth money you now have that would have been in a taxable account otherwise you now have earnings taxable at ordinary income levels. Of course, the most preferable option would be to dump the max amount in after-tax space in a given paycheck and immediately rollover once a year, but this is rarely afforded given either income levels or plan restrictions.

[jfoxcpacfp]

StarTrekDoc wrote:

If limited to once a year because of custodial constraints — wouldn’t ideal be max out ASAP and convert/distribute/rollover to the Roth that once a year?

It would be interesting if TRP actually has a counter showing how many has occurred over the year and would stop a distribution.

Click to expand...

We are all assuming growth here and, as we know, that's not the reality of the stock market in the short term. I would recommend simply keeping the contributions in a MMA until the annual conversion (or whatever timetable is required - one of our clients can convert quarterly) and investing after conversion.