Have you ever stumbled upon a financial strategy that seems to fly under the radar yet offers profound benefits for your retirement planning? Well, probably not because you’re not spending each and every day working on this stuff, but I have, and I want to share it with you. Enter the world of voluntary after-tax contributions, a lesser-known yet potent tool in your retirement savings arsenal.

Understand the Basics

Voluntary after-tax contributions refer to a type of contribution that can be made to an employer-sponsored retirement plan, like a 401(k). Unlike traditional pre-tax contributions that lower your taxable income now and get taxed upon withdrawal — or designated Roth contributions that are taxed now but withdrawn tax-free — voluntary after-tax contributions occupy a unique (and flexible) middle ground.

Eligibility and Limits

Now, I’ll dish out the bad news. What sets this type of contribution apart is its rarity. Not all employer-sponsored plans offer the option to make after-tax contributions; in fact, very few do, making it a unique opportunity for those who have access.

Where will you find voluntary after-tax contributions? Usually in the very largest and very smallest employer-sponsored retirement plans. Think of 401(k) plans for the largest corporations in the world and 401(k) plans for sole proprietors — business owners who are the one and only employee of their business. In either case, for high-income earners, in particular, if you have already maxed out your salary deferral (pre-tax and/or designated Roth) contributions, voluntary after-tax contributions can be a highly strategic way to further bolster retirement savings.

If your plan allows for voluntary after-tax contributions, the amount you can contribute is dependent on two factors:

1. How much you contribute as a regular salary deferral for both

• Pre-tax
• Roth

2. How much your employer contributes to your account as

• Matching contributions
• Profit-sharing contributions
• Other non-elective contributions

Each year, the IRS sets a limit on the total amount that can be added to an employer-sponsored retirement plan account. This limit is known as the Section 415 Limit or the Annual Additions Limit. We’ll just call it the “additions limit.” But note that this is not the same as your contribution limit, which is a part of the additions limit.

In 2023, the additions limit is $66,000. In 2024, the additions limit will be $69,000.

Let’s assume you make the maximum pre-tax salary deferral contribution of $22,500 in 2023, and your employer does not match your contribution or otherwise contribute to your 401(k). Your maximum voluntary after-tax contribution would be $43,500, which is calculated by subtracting the $22,500 salary deferral contribution from the $66,000 additions limit.

If you make the same contribution, but your employer also matches $10,000 of your contribution, your maximum voluntary after-tax contribution would be $33,500, which is calculated by subtracting the $22,500 salary deferral contribution and the $10,000 employer matching contribution from the $66,000 additions limit.

Note that the catch-up contribution limit of $7,500 (in both 2023 and 2024) is separate from the additions limit. In short, if you’re 50 or older, you can add $7,500 to the totals above.

The Strategy: From Voluntary After-Tax to Roth

Important distinction: A voluntary after-tax contribution is not the same as a designated Roth — sometimes called a “Roth after-tax” or just an “after-tax” (without the leading “voluntary”) — contribution. However, if your employer’s plan permits and you plan carefully, you can turn a voluntary after-tax contribution into Roth balance.

The real magic of voluntary after-tax contributions lies in their potential to be converted to Roth balance. Imagine being able to get up to $43,500 ($46,000 in 2024) into a Roth balance without paying tax on the conversion and in addition to your salary deferral contribution to your 401(k) plan or your Roth IRA (or backdoor Roth IRA) contribution. This strategy is especially beneficial for those who anticipate being in a high(er) tax bracket in the future, offering a chance to lock in today’s tax rates.

Mega Backdoor Roth Conversion: Why Convert to Roth?

More bad news: Your voluntary after-tax contributions won’t grow tax-free in your 401(k) if you just make the contribution and do nothing else. That’s because, while the contribution is made on an after-tax basis, the growth is considered a part of your pre-tax balance. However, by performing a rollover to the Roth balance in the 401(k) or to a Roth IRA, you will unlock the power of tax-free growth.

Unlocking the Power of Tax-Free Growth: Timing and Tax Considerations

As we’ve seen, voluntary after-tax contributions open up new avenues in retirement planning. But how do you make the most of this opportunity? It’s all about understanding the nuances and aligning them with your financial goals.

Here’s where strategy plays a crucial role. The process of converting your voluntary after-tax contributions to a Roth balance is known as the “Mega Backdoor Roth Conversion” strategy. It’s a powerful tool, particularly for high earners. The strategy involves making voluntary after-tax contributions to your 401(k) and then rolling over these funds to a Roth balance immediately.

Timing is key in the Mega Backdoor Roth process. Ideally, you want to minimize the time between making the voluntary after-tax contribution and converting it to Roth balance. Why? Because any earnings on voluntary after-tax contributions in your 401(k) before the rollover are subject to regular income tax, and you will have to pay tax on those earnings when you do the conversion. Quick (or better yet, instantaneous) conversions can help limit or eliminate these taxable earnings.

Future earnings on these Mega Backdoor Roth funds will not only grow tax-free but can also be withdrawn tax-free in retirement, assuming you meet certain conditions. This is a significant advantage, especially if you expect your tax rate to be high(er) in the future.

The Pro-Rata Pitfall You Want to Avoid

One major pitfall to avoid is misunderstanding the tax implications. It’s important to remember that, while the contributions are after-tax, any earnings on those contributions before conversion are subject to taxation. Miscalculating or mistiming this can lead to unexpected — and even massive — tax bills.

Be mindful of something called the pro-rata rule, which can complicate the tax scenario if you have pre-tax funds in your 401(k) and your plan does not separately account for voluntary after-tax contributions and associated growth. If your plan treats all non-Roth balances the same, your voluntary after-tax contributions may be indistinguishable from your pre-tax contributions and growth. Converting any part of your non-Roth balance to Roth in such a plan would mean that some of the conversion will be attributed to pre-tax contributions and growth, making it taxable.

Another consideration is the timing of your conversions. As mentioned earlier, timing plays a pivotal role in minimizing or eliminating tax on earnings. Quick or instantaneous conversions are generally preferable.

A Hidden Gem in Retirement Planning

Voluntary after-tax contributions are indeed a hidden gem when used for their highest and best use. While not applicable to everyone and certainly not without complexity, for those who have the opportunity and the right financial circumstances, they can be a game-changer.

Remember, the journey of financial planning is as unique as your personal financial goals. Strategies like these are powerful, but they are most effective when tailored to fit your individual situation. These opportunities could be the key to unlocking a more prosperous and secure financial future.