What Is an After-Tax Contribution?

An after-tax contribution is the contribution made to any designated retirement or investment account after taxes have already been deducted from an individual's or company’s taxable income. After-tax contributions can be made on either a tax-deferred or non-tax deferred basis, depending on the type of account the entity is making contributions into.

Key Takeaways

  • After-tax contributions are those made to a qualified retirement or investment account using money that has already been subject to eligible income tax.
  • After-tax contributions in Roth IRA accounts will subsequently grow tax-free, as opposed to the tax-deferred growth found in traditional IRAs that use pre-tax dollars.
  • It is an individual's own responsibility to keep track of after-tax contributions and their status to ensure proper tax treatment in the future.

Understanding After-Tax Contributions

Contributions made to a retirement savings plan can be pre-tax and/or after-tax contributions. If the contribution is made with money that an individual has already paid tax on, it is referred to as an after-tax contribution. After-tax contributions can be made instead of or in addition to pre-tax contributions.

A lot of investors like the thought of not having to pay taxes on the principal amount when they make a withdrawal from the investment account. However, after-tax contributions would make the most sense if tax rates are expected to be higher in the future.

After-tax retirement plan account balances have two components—the original after-tax contributions made to the plan and the tax-deferred earnings. Although the original contributions can be withdrawn at any time tax-free, any earnings or growth made in the account will be taxed when withdrawn.

After-Tax Contributions and Roth IRAs

A Roth IRA is a retirement account in which earnings grow tax-free if the money is held in the Roth IRA for at least five years. Contributions to a Roth are made with after-tax dollars, and as a result, they are not tax-deductible. However, you can withdraw the contributions in retirement tax-free.

Just like traditional IRAs, Roth IRAs have limits on how much can be contributed each year. The annual contribution limit for both Roth and traditional IRAs is $6,000 for 2020 and 2021. For individuals aged 50 and over, they can deposit an additional catch-up contribution in the amount of $1,000.

After-tax contributions into Roth IRAs are helpful because any money earned on the contributions through investments grows tax-free. In other words, an investment that's sold won't have taxes on those gains until the money is withdrawn in retirement. However, any contributions that are withdrawn in retirement are not taxed.

Early Withdrawal Tax Penalty

In addition to the tax applied, earnings that are withdrawn before the account holder turns 59½ years old will be subject to an early withdrawal tax penalty. Contributions made to a tax-deferred account, such as a 401(k), 403(b), and traditional IRA, require the individual to claim these contributions on his or her income tax return each year. As a result, the taxpayer is entitled to a refund based on his or her contributions at the going tax rate.

When an account holder leaves his company or retires, the Internal Revenue Service (IRS) allows them to roll the tax-deferred earnings into a traditional IRA and roll the after-tax contributions into a Roth IRA. The amount held in the traditional IRA will not be included in the individual’s income for tax purposes until it is distributed or withdrawn.

Advantages and Disadvantages of After-Tax Contributions

Withdrawals of your after-tax contributions to your (traditional) IRA should not be taxed. However, the only way to make sure this does not happen is to file IRS Form 8606. Form 8606 must be filed for every year you make after-tax (non-deductible) contributions to your traditional IRA and for every subsequent year until you have used up all of your after-tax balance.

The disadvantage of after-tax contributions is that since the funds in the account are separated into different components, figuring the tax that is due on the required distributions may be more complicated than if the account holder had made only pre-tax contributions.

Example of After-Tax Contributions

For example, consider an individual that has $25,000 in a Roth IRA. Of this amount, $22,000 represents after-tax contributions, and $3,000 is what she has earned from her investments. Her earnings growth is thus $3,000 / $22,000 = 0.1364, or 13.64%.

An emergency occurs, which prompts her to withdraw $10,000 from this account. The IRS will tax the earnings portion of this withdrawal, that is, 0.1364 x $10,000 = $1,364. The after-tax contribution portion, determined to be $10,000 - $1,364 = $8,636, is tax-exempt.