You’ve Maximized Your 401(k). Should You Invest After-Tax in an IRA?
If you have contributed the maximum to your 401(k) plan, you may want to consider additional after-tax savings in an IRA. While the contribution will not be tax-deferred, it will grow tax-free and can provide an additional source of income during retirement. Since contributions are made with after-tax dollars, withdrawals are tax-free, and only the growth will be taxed in retirement, which gives you some control over income.
It can be a good plan for additional savings that you won’t have to manage from a tax perspective, the way you do your taxable investment accounts. But of course, there is some paperwork you’ll need to stay on top of.
The Basics: Setting up the Account
If your primary (or only) vehicle for retirement savings has been through an employer-sponsored tax-deferred account like a 401(k), you may be a little surprised by the process of opening an IRA. With a 401(k) account, you specify the percentage you want to contribute pre-tax and how you’d like to allocate your investment, and all record-keeping is done for you. The amount you contributed will be reported on your W-2, but you don’t have to do any additional tax reporting or filing.
Contributing after-tax dollars to an IRA is more complicated. The account opening process is simple enough and can be done at various financial institutions. All reporting and rule-following is on you, which is why we recommend consulting your financial advisor when implementing this retirement savings vehicle. The institution likely will have some guardrails in place so you can’t contribute more than the $6,500 maximum for 2023 ($7,500 if you are over 50). You’ll need to keep track of your investments and file the necessary IRS forms yourself or with your CPA.
About Those Forms…
Balances in your 401(k) are contributed pre-tax and grow tax-deferred, so you pay taxes when you withdraw the funds in retirement. After-tax IRAs are a combination thereof – the original contributions are post-tax, so you can withdraw them without tax liability, however the growth is tax-deferred.
This is where the slight difficulty comes in. You need to file Form 8606 with your taxes every year that you contribute. Then you’ll need to save those tax forms until retirement so that you can prove to the IRS when you withdraw the funds in retirement that you’ve already paid taxes on the contribution. You can remedy it by filing the form with your next tax return if you forget.
Given the ease of electronic filing and record-keeping, maintaining organized records of your contributions is very manageable, even if your withdrawals are decades away. It’s not nearly as difficult as it is to keep track of your crypto wallet and keys.
How Do Withdrawals Work?
Again, if you aren’t familiar with the IRA structure, it can seem complicated. There’s a formula that calculates the tax-free and the taxable percentages. You utilize this formula to update Form 8606 to reflect the pro-rata tax-free withdrawal and your new adjusted basis (the amount of after-tax dollars still invested). Record-keeping is an ongoing theme with an after-tax IRA.
What are the Advantages?
Being able to put money away for tax-deferred growth can benefit retirement savings. Similar to your 401(k), you can structure the account to invest in holdings and assets of your choice, and you don’t need to be mindful of the impact on your annual taxes of your investment decisions, the way you do if you put money away in a taxable account.
However, you need to understand that when you do indeed eventually withdraw funds, taxes on the taxable portion (the tax-deferred growth) are calculated at the ordinary income rate, not the capital gains rate. Depending on your taxable income in retirement, this may be lower or higher than the earned income rate.
The Bottom Line
As tax season nears its end, thinking through all the available options open to you is wise. We encourage you to explore these retirement and savings tools with your financial advisor.
Brandy Branstetter, CFP®