Amazon After-Tax 401(k) Contributions, What Are They and Are They Worth It?

Recently, a client and I were talking about next steps to savings, now that his employee contribution to his 401(k) is maxed out for the year. He, as well as many of his peers, is in a high tax bracket and wants to maximize his retirement savings, and avoid taxation as much as possible.

At Amazon, and many other companies, the 401(k) retirement plan allows for contributions that are Pre-Tax, Post-Tax, and After-Tax which can lead to confusion and potential lost wealth through taxation if not fully understood. Because of this, let's dive into why you might want to contribute to the After-Tax portion of the plan, what the limits are, and why you might want to avoid doing After-Tax contributions.

What Are After-Tax Contributions?

After-Tax Contributions are savings amounts to the plan that are exactly that, contributed after taxing your income has occurred. This, just like a taxable brokerage you might have, can be invested into the plan and grow based on the investment choices you choose, with dividends taxed at your current income tax rate. The big difference here, and it's quite a big difference, is that gains in this account are taxed at your income tax rate, and not at the Long-Term Capital Gains tax rate you would otherwise receive by holding an investment in a brokerage account for longer than 1 year.

Consider this scenario. You are 45 years old and are contributing $10,000 to both an After-Tax 401(k) account, and a separate Individual Brokerage account held outside the plan. After 15 years of contributions, and growth at 6%, your 60 year old self now wants to take this money and use it for a larger purchase. Let's look at how your now $246,725 per account will be taxed:

Taxable Account: Account Value: 246,725 - Basis: $150,000 = $96,725 x Long Term Capital Gains Tax: 15% = $14,509

After-Tax 401(k): $96,000 x Income Tax Bracket of 24% = $23,214

A difference of $8,705 in lost wealth. And it get's larger from there if you are in a higher income tax bracket.

So Why Use an After-Tax 401(k) Account?

An After-Tax 401(k) Account allows you to contribute, with some restrictions, up to the total 401(k) savings limit of $61,000 in 2022. This higher limit includes your employer contributions as well so you as the employee will never be able to contribute the total yourself unless your employer does not give you matching or profit sharing. The big advantage here, until tax laws change, is that After-Tax contributions can be converted to your Roth 401(k) balance. This is called a Mega Backdoor Roth contribution and can either be something that is easy to implement or very difficult depending on the help your employer provides. In the case with Amazon, only 10% of the employee salary can be used for After-Tax contributions, but a simple click of a button will convert the money to your Roth account. Other employers offer no such tracking or automatic conversion option which requires the employee to manage everything on their own, and can lead to tax consequences if done incorrectly.

This Mega Backdoor Roth conversion can be quite the advantage though. Consider the same example above, but with the $10,000 being converted every year. That $146,725 of gain will be completely tax free, no matter what tax bracket you are in, which can make a significant impact on your future wealth.

Key Takeaways

After-Tax contributions can be a powerful tool in your pursuit to achieve financial freedom, but without the ability to convert them to your Roth Account, they do not make any financial sense. In addition, funds placed in 401(k) type accounts can be harder to obtain before age 59 1/2 than Roth IRA funds, and will be limited to the investments within the plan. Before contributing to After-Tax, ensure you are maximizing your employee contributions to either your Traditional or Roth account within your 401(k), and ensure your cashflow can handle the additional savings. Taxation is a very important piece to your financial puzzle and should be considered whenever placing funds into retirement accounts. Tax laws and 401(k) are always changing so it is important to stay up to date on what is affecting your plan for the future.

Speaking with a financial professional such as myself is always a good idea. If you have any questions regarding After-Tax Contributions, or if you are unsure if they are right for you, give me a call today at 615-567-3624 or email me at [email protected] and I'm happy to help!