March 27 brings us the Motley Fool Answers podcast's monthly mailbag show, which Alison Southwick and Robert Brokamp dedicate to providing their best advice and insights in response to listener questions.
Our podcasting duet learned something last month: Having Ross Anderson, certified financial planner from Motley Fool Wealth Management -- a sister company of The Motley Fool -- along for the ride makes it so much easier.
In this segment, they look at a less common option when it comes to 401(k)s. That annual contribution limit you have always heard about? It's not strictly the limit -- some employers let you contribute more. But if you do, you don't get all the benefits you're used to.
A full transcript follows the video.
This video was recorded on March 27, 2018.
Alison Southwick: The next question comes to us from Brandon. My employer offers three 401(k) options: the traditional free tax plan, a Roth, and an after-tax option. This after-tax option seems like the worst of both worlds. You are taxed on money going in and taxed on distributions. Is there an advantage to using this option over the others that I'm not seeing?
Ross Anderson: All right. Brandon is talking about a feature that not every employer's 401(k) has but is an interesting one. The after-tax feature is normally used if you've already maxed out your pre-tax or your Roth contributions. In 2018, if you are below 50 years old, you can put in $18,500. That's gone up, so if you were trying to max out and last year you were at $18,000 you can put an extra $500 in this year, so that's good. If you are over 50, that limit goes up by another $6,000 for the catch-up, so up to $24,500 for the year.
But if you are already doing that and you wanted to continue saving beyond that, you're not allowed to do more pre-tax or Roth money into the 401(k), but you can still contribute in an after-tax fashion. After-tax basically means that you are still paying income taxes on that money, but it's going into the 401(k) and it is tax-deferred.
So, buying and selling short-term, capital gains, all that type of stuff is avoided and when it comes out of the 401(k), you're going to pay income taxes on the gains. It's kind of like an annuity, in that way, if you had a tax-deferred annuity. So, after-tax money in, tax-deferred growth, you pay taxes on the gains coming out.
The other popular use of this is for backdoor Roth conversions. If you put a bunch of money -- if you stuff money -- into that after-tax feature, you can then do a Roth conversion on that piece when you get to retirement and you've separated from service, so you can kind of isolate that amount of your 401(k). Again, it's kind of a lower-cost version of doing a Roth conversion because you have basis. You have actual money that's already after-tax inside the account.
It gets kind of complicated. I realize that's tough to follow just listening to it, but that's really why the after-tax feature is there. It's not intended to be the first thing that you choose, but if you're already maxing out, it could be something to consider.