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Perhaps the best way to
answer this question is to look at the following comparison between pre- and post-tax
401(k) contributions.
Pre-Tax Contributions:
Both the contributions you make to your account and the investment gain continue to grow
tax-free until you withdraw money from your account at retirement.
As you take money out of your 401(k), you pay taxes only on the amount you withdraw (so
that at retirement, taxes don’t come due on your entire account balance at once).
Because your 401(k) contribution is deducted from your compensation before taxes are
calculated, your taxable income is lower, so you pay less income tax.
If you withdraw money from your 401(k) account before age 59 ý you will generally have to
pay a penalty (except in cases of a qualified financial hardship as defined by the IRS).
Post-Tax Contributions:
Because post-tax contributions are made with money you've already paid taxes on, only the
investment's gain or income (i.e. interest and dividends) – and not your
contributions – enjoy the benefit of tax-deferred growth.
When you withdraw post-tax 401(k) funds you only pay taxes on the gain (interest or
dividends) your investment has earned. As with pre-tax contributions, taxes are due only
when you take money out of your account.
Post-tax contributions are not tax-deductible, so you don't get a tax break for making
them.
Depending on your plan's rules, you may be able to withdraw your post-tax contributions at
any time without incurring a penalty. However, because the gain you earn on your post-tax
401(k) investment is tax-deferred, you must pay income tax on that amount when you
withdraw your money. The gain is also subject to an early withdrawal penalty if withdrawn
before age 59 ý (except in cases of a qualified financial hardship as defined by the
IRS).
Now, considering that the best tax break and the greatest opportunity for taking advantage
of tax-deferred compounding come with pre-tax 401(k) contributions, why would anyone
consider making post-tax contributions?
Here are some possible scenarios:
ý If you are already making the maximum pre-tax 401(k) contribution allowed and really
want to contribute more (to get the benefit of tax-deferred investment growth).
ý If your employer matches both pre-tax and post-tax contributions, and you are fully
vested for matching contributions, you might choose to maximize the employer match by
making the maximum allowable pre-tax contribution and making post-tax contributions as
well.
ý If you are committed to saving money, but aren’t sure you’ll be able to leave
your money invested until retirement, you might make after-tax contributions because you
will be able to withdraw them without penalty before age 59 ý. A person considering this
idea needs to remember that the gain earned on the investment is subject to an early
withdrawal penalty if taken out before age 59 ý. Also, income tax on the investment gain
is due at the time of withdrawal.
The 401(k) is an investment vehicle for retirement. If retirement is not the goal, there
is probably a more appropriate vehicle for post-tax investment dollars. |
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