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This lesser-known 401(k) feature is a ‘no-brainer’ for big savers, advisor says

Year-end Planning
  • If you’re itching to save more into your 401(k) for 2023, your plan may have a feature that allows you to bypass the yearly deferral limit.
  • Only 10% of employees with after-tax 401(k) contributions took advantage of the feature in 2022, according to Vanguard.
  • But experts say it’s better to max out employee deferrals first to claim your 401(k) match.
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If you’re itching to save more into your 401(k) for 2023, your plan may have a feature that allows you to bypass the yearly deferral limit.

For 2023, you can funnel $22,500 into your 401(k), plus an extra $7,500 if you’re 50 or older. But so-called after-tax contributions can exceed those limits. The max 401(k) limit for 2023 is $66,000, including employee deferrals, after-tax contributions, company matches, profit sharing and other deposits.  

After-tax contributions are a “no-brainer” if you make enough to comfortably save beyond the 401(k) employee deferral limit, said certified financial planner Dan Galli, owner of Daniel J. Galli & Associates in Norwell, Massachusetts.

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However, only 10% of employees with after-tax deferrals took advantage of the feature in 2022, and those who contributed typically had higher incomes and longer job tenure, according to Vanguard’s 2023 How America Saves report.

“There are many advantages — unless you need the money between now and retirement,” Galli said.

Still, many 401(k) plans don’t offer after-tax contributions due to plan design restrictions, he said. Indeed, only 22% of plans provided the option in 2022, according to the same Vanguard report.

Max out 401(k) deferrals first

Before taking advantage of after-tax contributions, you’ll want to max out pretax or Roth deferrals to capture your employer match, said CFP Ashton Lawrence, director at Mariner Wealth Advisors in Greenville, South Carolina.

“Then we can have a conversation about where your next contribution dollars will go,” he said. “For some people, after-tax contributions may not be appropriate.”  

Typically, advisors use a “holistic approach” when deciding where to allocate funds, including the client’s goals, timeline and other factors, Lawrence said.

Move the funds to ‘avoid taxation’ on growth

After-tax and Roth contributions are similar because both start with after-tax deposits. However, while Roth contributions grow tax-free, after-tax deposits grow tax-deferred, meaning you’ll owe income taxes upon withdrawal.

With that in mind, once you make after-tax 401(k) contributions, it’s important to periodically convert those funds to a Roth account to kickstart tax-free growth.

“It’s widely assumed that Roth conversions are always done in Roth individual retirement accounts,” Galli said. But you might use in-plan conversions to move the funds to your Roth 401(k) rather than an IRA, which may provide cheaper investment options and certain protections. 

By doing this right, you can essentially avoid taxation on all growth, and that’s where the magic is.
owner of Daniel J. Galli & Associates

Upon conversion, you’ll owe levies on after-tax contribution growth, which is why Galli suggests converting the funds to Roth accounts at least quarterly. “By doing this right, you can essentially avoid taxation on all growth,” he said. “And that’s where the magic is.”

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Source: Investing - financial advisor - cnbc.com

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