You've Maximized Your 401(K). Should You Invest After-Tax In An IRA?

As tax season approaches, thinking through all the available options open to you is just smart money.


If you have contributed the maximum to your 401(k) plan, you may want to consider additional after-tax savings in an IRA account. While the contribution won't be tax-deferred, it will still grow tax-free and can provide an additional source of income in retirement. And since you contributed with after-tax dollars, you can withdraw them 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 recordkeeping 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. But all the reporting and rule-following is on you. The institution likely will have some guardrails in place so you can't contribute more than the $6,000 maximum ($7,000 if you are over 50). But that’s about it. You’ll need to keep track of your investments and file the necessary IRS forms yourself.


About Those Forms…


Balances in your 401(k) are contributed pre-tax and grow tax-deferred, so you pay the taxes when you withdraw funds in retirement. After-tax IRAs are a mix – the original contributions are post-tax, so you can withdraw them without tax liability, but 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 recordkeeping, it's not that big of a deal even if this is decades away. It's not even close to how difficult it is to keep track of your crypto wallet and keys.


But if you don't do it, you will pay taxes on the contribution amounts twice.


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. Then you update Form 8606 to reflect the pro-rata tax-free withdrawal and your new adjusted basis (the amount of after-tax dollars still invested). So, recordkeeping is an ongoing thing.


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 anything you want, 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 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.


One other consideration – opening the after tax-IRA is the first step to the Backdoor Roth. If you are uncertain about whether that provision will make it through whatever the final version (if any) of the Build Back Better Act is, and you want to wait until after the mid-terms, it’s a way to preserve your options. And if ending the long-term capital gains advantage end up back on the chopping block, you’ll be ahead of the game.


The Bottom Line


As tax season approaches, thinking through all the available options open to you is just smart money.


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