Why I Stopped Making Voluntary After Tax Contributions

When I started my current job, I was ecstatic that I finally had a 401k.  None of my prior employers had offered it.  Sure, I wanted matching too, but fewer employers in my industry offer matching these days.  At least now, I could minimize my taxable income while saving for retirement.

Only, I didn’t.  Rather than do my research, I followed a colleague and used the following contribution plan:

  • Tax Deferred Contribution – $10,000 per year
  • Roth 401k Contribution – None
  • Voluntary After Tax Contribution – $8,000 per year

Before I get into why this was a bad decision, let’s take a step back and explore the mechanics of these three types of contributions.

Tax Deferred Contributions

Tax deferred contributions are contributions that are not taxed until withdrawal.  The maximum contribution you can make to a tax deferred account in 2016 is $18,000 if you’re under 50 years old.

What this means now

You pay less taxes.  When you make a tax deferred contribution from your current paycheck, your overall taxable income for that year decreases.

What this means later

You pay taxes later when you withdraw from your tax deferred account.  If you withdraw before age 59 1/2, you pay ordinary income taxes and an additional 10% Federal tax penalty.  If you withdraw after age 59 1/2, you only pay ordinary income taxes on the withdrawal.  Keep in mind that if you have no problems saving money now, you probably won’t need to withdraw that much during retirement.  This assumes that you have lots of savings in your taxable accounts, no outstanding debt and do not pay rent (i.e. you purchased your home and paid off the mortgage).  In that case, you can live off your taxable accounts and make small withdrawals each year, minimizing your taxes during retirement.

Roth 401k Contributions

Roth 401k contributions are taxed now and grow tax free.  You pay no taxes when you make qualified withdrawals.  The maximum contribution you can make to a Roth 401k account in 2016 is $18,000 if you’re under 50 years old.

What this means now

You pay the same amount of taxes as if you had not contributed at all.  Roth 401k contributions do not decrease your overall taxable income.

What this means later

You pay no taxes if you withdraw after age 59 1/2.  If you withdraw before that, you pay both ordinary income taxes and a 10% Federal tax penalty on your gains.  If you think you’ll need more money during retirement than you do now (i.e. you plan on supporting your children or buying a larger house), you may want to consider making Roth rather than tax deferred contributions.

Voluntary After Tax Contributions

Voluntary after tax contributions are taxed now and grow tax deferred.  You will pay taxes on your gains when you withdraw.  The maximum contribution you can make to a voluntary after tax retirement account in 2016 is $53,000 if you’re under 50 years old.

Recently, the IRS passed new regulations that allow voluntary after tax contributions to be rolled over into a Roth account (IRA).

What this means now

You pay the same amount of taxes as if you had not contributed at all.  Voluntary after tax contributions do not decrease your overall taxable income.

What this means later

You pay taxes on any gains in your account when you withdraw.  If you roll over your contributions into a Roth account, you pay taxes on any gains that happened before the rollover.  If you withdraw before age 59 1/2, you’ll pay both income taxes and a 10% Federal tax penalty on your gains.

My Retirement Plan

So back to my retirement plan, not only was I not maxing out my tax deferred contributions to $18,000, I was locking away $8,000 in voluntary after tax contributions that served no tax advantages for me.  Sure, tax deferred gains and the ability to roll over into a Roth account are nice, but I don’t expect that I’ll need more money each year after retirement than I do now.  I comfortably save more than 50% of my income and do not expect to be paying Manhattan rent prices when I retire.

I would much rather grow a taxable investment account that provides more liquidity so that I can withdraw cash at any time for emergencies or a down payment on a home.  Here’s my current retirement plan:

  • Tax Deferred Contribution – $18,000 per year
  • Roth 401k Contribution – None
  • Voluntary After Tax Contribution – None

Conclusion

If you comfortably save off of your current income like me, you could minimize your income taxes now by maxing out your tax deferred contributions.  You could then live off the savings in your taxable accounts and make small withdrawals from your 401k, minimizing your income taxes during retirement.

If you plan on needing more income during retirement, then Roth and additional voluntary after tax contributions might work for you.  In this case, you’ll probably want to max out your Roth contributions before making voluntary after tax contributions.

Keep in mind that everyone’s situation is different, so you’ll want to carefully consider each type of contribution and how it affects your financial goals before making a decision.

(Featured image from my Charles Schwab retirement account)




April 2016 Net Worth Update
Talking Finances with Loved Ones

5 thoughts on “Why I Stopped Making Voluntary After Tax Contributions

  1. Nice article. Just wondering…did your colleague have any particular reason for structuring his contribution plan the way he did?

    1. I’m not sure if he did! When I spoke with him again, he too had stopped his voluntary after tax contributions. He now diversifies with a mix of tax deferred and Roth contributions, which may be useful for those who are not yet sure what they’re retirement plans are.

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