TECHNICAL GLOSSARY

After-Tax Contributions: What Business Owners Need to Know

Understanding how retirement contributions are taxed can play an important role in a small business owner and self-employed contractor’s long-term financial planning. An example of a type of retirement contribution that has tax advantages is after-tax contributions which may provide different opportunities for contribution methods after your pre-tax contribution limit has been reached.

What Are After-Tax Contributions?

After-tax contributions (of income that had already been subject to tax) can be made into a retirement account. Unlike traditional 401(k) or traditional IRA pre-tax contributions, making an after-tax contribution does not decrease taxable income in the year the contribution is made. Depending on the account type, you may be able to contribute 100% of your net pay (after federal tax) to employer-sponsored retirement plans including 401(k) plans or Roth accounts if eligibility restrictions exist; although you will not receive an immediate tax deduction, any earnings on your after-tax contributions will still accrue tax-deferred while held in your IRS-qualified retirement accounts.

How After-Tax Contributions Are Taxed

After-tax contributions do not allow you to deduct income taxes from income taxable at the time of distribution but offer better tax treatment for future distributions.

• Contributions: Since the taxes were already paid, you will receive a distribution of your original contribution amount tax-free.
• Investment earnings: The earnings can grow either tax-deferred or tax-free depending on the type of account you open to hold your after-tax contributions.
• Withdrawals: Roth-IRA qualified withdrawals from a Roth account will be free of tax in most cases; However, if you draw from an after-tax contribution in a 401K or if you make a non-qualified withdrawal, then you may have to pay tax on earnings at ordinary income tax rates.

Taxpayers will be held to a high standard of accuracy when reporting after tax amounts to the IRS, and the IRS will require that any after tax amount be properly accounted for throughout the period before any distribution to the taxpayer.

Pre-Tax vs. After-Tax: Which Is Better?

There isn't one answer for this question. You must consider your present income, anticipated retirement tax bracket, and the overall business cash flow when making your decision.
Pre-tax Contributions

• Decreases your taxable income for the current year.
• Your IRS's current year's tax liability will be lower.
• Withdrawals will be treated as ordinary income in retirement.

After-tax Contributions

• You don't get a tax deduction this year on the contribution.
• You have the ability to grow your investment tax-free or on a tax-advantaged basis.
• If you think taxes will be higher than they are today, this may be a good option.

After an owner has maxed out the amount they can contribute pre-tax, they frequently make after-tax contributions. This is generally a part of a long-term tax diversification strategy for business owners that have a lot of income this year.

How Are After-Tax Contributions Recovered?

The Internal Revenue Service permits tax-free withdrawals of after-tax deposits when you receive retirement funds; your after-tax deposits have already been paid taxes. However:

• For example, withdrawing funds before turning 59½ could create an income tax and/or 10% penalty for earnings on the account.
• Distributions made that are considered non-qualified could provide tax consequences for the account's earnings as well.
• Tax form(s) must be properly filed to avoid the taxes being paid on the same money twice, i.e., double taxation.