As income rises, one of the bigger decisions that savers face is where to invest extra funds. If you’re already maxing out your 401(k) or retirement account, then this gives you a few options to consider with that extra savings.
Few people realize the value that these after-tax deferrals can have on the long-term savings of your portfolio. CNBC reported that the Vanguard 2023 How America Saves study found that 10% of employees with after-tax deferrals used the feature last year, while 22% of plans offered such a feature.
In a 401(k), you’re able to set aside up to $22,500 if you’re under 50 years old and receive a tax benefit from that. After you’ve set aside that mark, you can continue to add funds to your 401k, using deferrals, profit sharing, employer contributions and other sources, up to a total of $66,000 for the year. It’s particularly advantageous for high-earning employees or self-employed individuals, that need to stock away more funds.
Does that mean more people should use such deferrals within the 401k? Well, it depends on the purpose of the funds, when you hope to retire, and what your plans are from a tax perspective.
Using the 401k for Deferrals
There’s value in sticking the extra funds in the 401k and allowing it to sit and grow.
The funds placed in the 401k will be invested, receive dividends and continue growing tax free, as long as you do not take out the funds for any reason. This allows portfolios to increase dramatically over many years, since it’s growing without paying capital gains on the growth.
Only at the time when you begin pulling money out of the 401k will you have to pay income taxes on the amount you withdraw. This gives you a valuable resource to expand your savings, which avoids tax concerns until later in life.
The downside? You cannot begin to pull funds out of the account until you’re 59½. If you do, then you will possibly pay a 10% fee on top of the taxes on the money that you pull out.
What could also impact many of those that are adding extra funds to a 401k, is that they don’t necessarily need the funds every year in retirement, since they have other assets contributing retirement income. But at 73, in a 401k, they will have to begin required minimum distributions (RMD). This can become a significant tax concern later in life.
Using the Roth 401k for Deferrals or Conversion
A common tactic for those deferring salary in a 401k will first contribute to the regular 401k, then convert it to a Roth before the funds are needed, so they can grow tax free and be used tax-free in retirement.
You can convert the funds. This requires taking any tax impact at the time of conversion.
One caveat, you have to wait five years, at a minimum, to pull out the funds, if you’re converting. If you believe you’ll need the funds sooner, then have a plan for the conversion.
The other wrinkle? Again, you must wait until 59½ to remove any gains, without suffering a penalty. You can, however, remove contributions if you invested directly via a Roth from the get-go. You also do not face RMDs on Roth 401ks beginning in 2024. This allows you to grow the account, without tapping it, unless you absolutely need to. It’s a new advantage for Roth 401ks, which can add tremendous value for high income earners late in life.
Using Extra Funds in a Taxable Account
There’s an important tax wrinkle in taxable brokerage accounts, which many savers could take advantage of. This is the fact that when paying capital gains taxes, you do not pay any taxes if your long-term capital gains – or assets you’ve held for longer than a year – are under $44,625 for single tax filers or $89,250 for married and filing jointly for the year.
This allows you an opportunity to build your assets for the long-term, investing in exchange traded funds (ETFs) that do not pay dividends, and have your assets grow tax free in that time frame. Meanwhile, if you need the assets at any point, you can pull out gains up to those limits, and not pay any taxes on the funds.
Since there’s no age-limit, it can have real value for those that want to retire early or want some flexibility for their long-term savings.
And, of course, there’s no RMDs in a taxable account.
Whether you use a regular deferral, a Roth 401k or invest more in a taxable account – or using all three – it’s important to understand where your funds are, and why you have chosen each specific account. With that in place, deferrals can become a powerful wealth generator.