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.
- 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 Although the original contributions can be withdrawn at any time tax-free, any earnings or growth made in the account will be taxed when withdrawn.
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In addition to the tax applied, earnings that are withdrawn before the account holder turns 59½ years old will be subject to an early withdrawal tax penalty.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, in which case, 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 him to roll the tax-deferred earnings into a traditional IRA and roll the after-tax contributions into a Roth IRA. A Roth IRA is an account in which earnings grow tax-free if the money is held in the Roth IRA for at least five years and until the individual clocks 59½ years old. The amount held in the traditional IRA will not be included in the individual’s income for tax purposes until it is distributed.
Example of After-Tax Contributions
For example, consider an individual that has $25,000 in a Roth IRA. Of this amount, $22,000 is the after-tax contribution, 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.
Pros and Cons 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.