Roth IRA contributions and voluntary after-tax contributions make a lot of sense for those who can afford them. The government's record deficits will force its hand and make it look for as many additional revenue streams as it can find. Currently, most 401K plans offer their participants a Roth contribution option. However, you do give up the tax deduction for that given tax year by contributing to the Roth IRA versus a traditional pre-tax contribution. A tax-free withdrawal at retirement could be worth today's pain.
As of 2024, those under 50 can contribute up to $23,000 a year to their 401K. If you are over 50, you can contribute an additional $7,500. If you file jointly and make over $201,050 a year, you’re in a marginal federal income tax bracket of 24%. Rather than reducing your taxable income by $30,500 by making a traditional pre-tax contribution, you will enjoy tax-free distributions at some point in the future. In this example, if you are over 50 and could make the maximum contribution of $30,500 to a Roth inside of your 401k, it would cost you roughly $7,320 in taxes for that tax year. It is not cheap, but like anything hard, it will feel good knowing that you have paid your taxes in advance and have one of the few vehicles for tax-free withdrawals at retirement. Plus, all the growth on your contribution is tax-free as it cooks towards your retirement.
The Voluntary After-tax inside of a 401-k plan
This one is a little trickier and is not offered in every 401k plan, but if you are lucky enough to have it as an option and are a high-income earner, it is worth looking into. If you are under 50, the total contribution you can make to your 401k, including your contribution and company matching, is $69,000 and $76,500 for those over 50. In this example, you are over 50 and want to make a pre-tax contribution, including your catch-up contribution of $30,500. The company you work for decided that it will also contribute $19,000 between its 401k contribution plan and profit-sharing plan. This leaves you with a total contribution between yourself and your company, $49,500. Suppose you can contribute a total of $76,500 in 2024, this would allow you to do an additional $27,000 in a VAT (voluntary after-tax plan). VAT comes in an after-tax contribution, and the gains on VAT contributions are taxed as ordinary income upon withdrawal. However, most plans allow you to move over your VAT contribution to a Roth inside your 401k, allowing the growth of that Roth portion to be distributed tax-free at retirement. Some 401ks allow you to do an early rollover to a Roth IRA outside of your 401k plan, which allows you to invest in any way you see fit.
Although these options seem complex, they could be worth your while if you take the time to understand them. If you believe that taxes are going to go up in the future, then it might be worth the pain of today for tomorrow's gain of tax-free withdrawals at retirement. Each person's situation is different, but you should discuss with your advisor what is the right fit for you.
Disclosure: The information herein is from sources regarded as credible, but Baird has not verified the accuracy or completeness of this material and as such, this should be regarded as for educational purposes only and is subject to change and potentially subject to ongoing interpretation.. It is strongly encouraged that clients speak with their tax or legal professional prior to acting on this information. The opinions expressed are those of the author and not necessarily those of Baird. Robert W. Baird & Co. Incorporated.