What you need to know about after-tax 401(k) contributions

Do you want to save more for retirement but you've already maxed out your 401(k) contributions for the year? You might be missing an opportunity for extra savings in your company's 401(k).

If your plan allows for after-tax contributions, you can save beyond the pre-tax annual contributions limits—and still have your contributions grow tax-free. While it's not the right strategy for everyone, it helps to understand the basics so you can make an informed decision on your savings.

After-tax 401(k) contributions: The basics

The IRS has two defined limits for annual contributions to a 401(k) plan each year: the pre-tax contributions limit and the total contribution limit. In 2022, those IRS limits1 are:

Pre-tax contribution limit: $20,500 ($27,000 for those age 50 and older)

Total contribution limit: $61,000 ($67,500 for those age 50 and older)

The total contribution limit includes employee contributions as well as employer matching contributions and profit-sharing contributions (which give employees a share of the company's profits based on its quarterly or annual earnings). For example, say you're under age 50 and make the maximum $20,500 pre-tax contribution to your 401(k) in 2021. If your employer's matching and/or profit-sharing program contribute another $14,500 and your 401(k) plan allows after-tax contributions, you could potentially save an extra $26,000 ($61,000 - $20,500 - $14,500) as after-tax contributions.

It's worth noting that not all 401(k) plans allow for after-tax contributions. A quick conversation with your HR department can get you the details on your company's plan.

Potential benefits of after-tax 401(k) contributions

The ability to save more for retirement just scratches the surface of the potential benefits of after-tax 401(k) contributions. You could also enjoy:

• Tax-deferred growth. If you make trades within your 401(k) account before retirement, you won't face capital gains taxes. And your dividends can be reinvested without incurring any taxes. The only time you'll pay taxes on your gains is when you begin taking distributions in retirement. (And note, you won't pay taxes on the after-tax principal you contributed.)
• A larger emergency savings cushion. Since you're making contributions after-tax, you can generally make withdrawals from these funds tax-and penalty-free.2 By contrast, tapping into your pre-tax contributions typically means incurring both early withdrawal penalties and taxes.3 (If you need to do either, speak with your tax advisor for details.)
• Possibility to roll over funds into a Roth IRA. You may be eligible to roll over your after-tax contributions into a Roth IRA using a strategy called a mega backdoor Roth IRA. Roth IRAs and after-tax 401(k) contributions are alike in that you fund them both with aftertax money. However, the earnings on an after-tax 401(k) contribution are taxable, while the earnings in a Roth aren't. A mega backdoor Roth allows you to convert your after-tax 40(k) contributions to a Roth account and lower your taxable income in retirement. Although you must pay taxes on the earnings when you roll the funds over, if you time it right you can minimize potential gains. A mega backdoor Roth is a highly nuanced strategy4 best discussed with your tax advisor. But if you qualify, it could help you access Roth IRA benefits even if your income is too high to contribute to one. Your tax professional can help keep you up to date.