When it comes to saving for retirement, many people have access to a 401(k) plan through their employers. A 401(k) plan allows you to contribute a portion of your pre-tax income to a retirement account, where it can grow tax-deferred until you withdraw it in retirement. You can also choose to make Roth 401(k) contributions, which are made with after-tax dollars but can be withdrawn tax-free in retirement.
However, the IRS imposes annual limits on how much you can contribute to a 401(k) plan. For 2024, the limit is $23,000 for most savers, and $30,500 for those who are 50 or older. If you exceed this limit, you will have to pay a 10% penalty for early withdrawal, as well as income taxes on the excess amount when you take it out.
But what if you want to save more than the 401(k) limit? One option is to open a traditional brokerage account, where you can invest in stocks, bonds, mutual funds, ETFs, and other securities. A brokerage account does not have any contribution limits, and you can withdraw your money at any time without penalty. However, you will have to pay taxes on any dividends, interest, or capital gains that you earn in the account.
Another option is to make after-tax contributions to your 401(k) plan, if your plan allows it. This means that you contribute money that has already been taxed, but can still benefit from the tax-deferred growth of the 401(k) plan. However, unlike Roth contributions, after-tax contributions are not tax-free when you withdraw them. You will have to pay taxes on the earnings that have accumulated in the account, unless you roll them over to a Roth IRA.
To illustrate the difference between these two options, let’s look at an example. Suppose you are 40 years old, earn $200,000 a year, and want to save $40,000 a year for retirement. You are already maxing out your pre-tax 401(k) contributions at $23,000 a year. How should you invest the remaining $17,000?
Option 1: Traditional Brokerage Account
If you invest the $17,000 in a traditional brokerage account, you will have to pay taxes on it first. Assuming you are in the 32% federal tax bracket and the 9.3% state tax bracket (for California), you will have to pay $7,091 in taxes, leaving you with $9,909 to invest. If you invest this amount in a diversified portfolio that earns an average annual return of 8%, you will have $42,766 after 10 years. However, you will also have to pay taxes on the dividends, interest, and capital gains that you earn in the account. Assuming a 15% tax rate on qualified dividends and long-term capital gains, and a 41.3% tax rate on interest and short-term capital gains, you will have to pay $6,414 in taxes, leaving you with $36,352 after 10 years.
Option 2: After-Tax 401(k) Contributions
If you make after-tax contributions to your 401(k) plan, you will not have to pay taxes on the $17,000 upfront, as you have already paid them. If you invest this amount in the same portfolio that earns an average annual return of 8%, you will have $37,115 after 10 years. However, you will have to pay taxes on the earnings when you withdraw them. Assuming you are in the 24% federal tax bracket and the 9.3% state tax bracket (for California) in retirement, you will have to pay $8,908 in taxes, leaving you with $28,207 after 10 years. However, if you are able to roll over your after-tax contributions to a Roth IRA, you will not have to pay any taxes on the earnings, and you will have $37,115 after 10 years.
Comparison
Here is a table that summarizes the results of the two options:
| Option | Initial Investment | After-Tax Value After 10 Years |
|---|---|---|
| Traditional Brokerage Account | $9,909 | $36,352 |
| After-Tax 401(k) Contributions | $17,000 | $28,207 (or $37,115 if rolled over to Roth IRA) |
As you can see, the traditional brokerage account has a higher after-tax value after 10 years, unless you can roll over your after-tax 401(k) contributions to a Roth IRA. However, this does not mean that the brokerage account is always better than the after-tax 401(k) option. There are other factors to consider, such as:
- Liquidity: A brokerage account gives you more flexibility and access to your money, while a 401(k) plan locks up your money until retirement (or until you leave your employer).
- Tax rates: The tax rates that apply to your income and investments may change over time, affecting the relative advantage of each option. For example, if tax rates go up in the future, the after-tax 401(k) option may become more attractive, especially if you can roll it over to a Roth IRA.
- Investment options: A brokerage account gives you more choices and control over your investments, while a 401(k) plan may have limited or expensive options.
- Fees: A brokerage account may charge you commissions, fees, or expenses for trading and managing your investments, while a 401(k) plan may have administrative or management fees that reduce your returns.
Passionate about finance news and updates, I’m your go-to guide through the twists and turns of the financial world. With a knack for breaking down complex topics into bite-sized insights, I’m here to make finance accessible and exciting for you.