We have already covered 401K and Roth 401K topics in detail in last two episodes.
There is another flavor of 401K other than these two called "After Tax 401K".
We will dig deep into that type in this episode.
Other than that, we will also look into how we can choose funds for our 401K plan.
Hi. My name is Vijay Mohan. You are watching - Investment Insights.
Many companies have started offering "After-Tax" 401K.
Many confuse this "After Tax" 401K with post tax Roth 401K. But this After Tax 401K is totally a different beast.
Just like in Roth 401K, we should pay the tax for the contributed money in After tax 401K as well.
While withdrawing after retirement, we don't have to pay tax on the contribution as we have already paid for it.
But we have to pay tax for the earnings from the contribution.
Also, the tax is not the standard 15% long term capital gains rate, but ordinary income tax rate.
When we can withdraw the whole amount tax free in a Roth, here in After tax, we can withdraw only the contribution tax free.
We have to pay tax on earnings like regular income.
This is the major difference between After Tax 401K and Roth 401K.
"I would rather invest in a brokerage", you might think. But this is better than a brokerage account.
If we sell a fund in a brokerage account, we have to pay taxes on the earnings from that fund in that year.
But in this after tax 401K, we don't have to pay taxes until our withdrawal after retirement.
Remember the "Tax deferred compounding" from the first 401K episode? We will get the same advantage here as well.
But if we are invested in an Index fund and if we are planning to hold it for long term without selling, then this plan does not have big advantage over a brokerage account.
But we can do a small trick on this one.
A special thing to note here in After tax 401K is, the standard contribution limit $20,500 is not applicable to this one.
The limit for this one is more. As per IRS, as of 2022, we can contribute up to a total of $61,000 in our 401K per year.
Our contribution, employer match and this after tax contribution - all will be included in this $61,000 contribution limit.
Let's say that we are contributing $20,500 to our pretax 401K.
And if our employer is matching up to $10,000, then we can contribute up to $30,500 in After Tax 401K.
"But there is no big benefit in contributing to After tax 401k, right?". True.
But in many companies that offer After tax 401K, they also offer an option called "In service distribution".
That means we can distribute the balance of this after tax 401K into another 401K account while working in the same company.
If your company offers an option like that, you hit a jackpot.
What you can do is, first max out your pretax 401K by contributing $20,500.
Then you can contribute extra amount into after tax 401K and then immediately move that contribution into Roth 401K. It is legally allowed to do that.
What have we done here essentially? We contributed money to an account which has tax for earnings, but moved into an account that has tax free earnings.
This process is called "Mega Backdoor Roth".
This process is explained really well in Nerdwallet site. I will include the link in the description.
"We are already exhausted to even max out a regular 401K...
"But you are talking about contributing even more thru after tax 401K and Mega backdoor Roth..." True.
This Mega Backdoor Roth is not going to be useful for all. But for folks who would like to contribute more into a tax advantaged account can take advantage of this.
We should remember one thing. We should consider After Tax 401K only after maxing out a regular pretax 401K, or Roth 401K or a combination of both.
We should not consider After tax 401K, before doing that.
There are few other things that we should know about a 401K.
For a 401K, 59.5 is the retirement age.
If we withdraw any money from a 401K before 59.5, then we have to pay 10% penalty and also tax on the withdrawal.
For a Roth, we have to pay 10% penalty and tax for the earnings. No need to pay tax for the contribution.
Another thing about 401K is, we have to withdraw a minimum amount after we reach 72.
That is called as RMD - "Required Minimum Distribution*".
Let's take a quick example calculation for that minimum amount. Let's say that we are 75.
It assumes that we would live up to 98. Difference is 23 years.
The balance of the account at that time will be divided by this 23 and we have to withdraw at least that amount for that year.
This is just an example rough calculation. For exact formula, check IRS website.
Next 401K Inheritance. If something happens to us, our spouse can inherit our 401K balance.
They can directly roll over this 401K balance into their 401K or their IRA. We will take a closer look at IRA in next episode.
If we do not have a spouse, our beneficiaries will get our balance as inheritance.
They have 2 main choices.
Withdraw everything and pay the income tax immediately. Or withdraw the money little by little within next 10 years.
But when they do that, this withdrawal amount will get added to their income.
They will be forced to pay tax at their highest marginal tax rate.
Now we know about 401K pretty well. But there are many funds to choose from. How can we choose the right fund for us?
It is better for a conservative investor to invest in a "Target Retirement" fund.
Almost all employers offer this target retirement fund.
If your plan is to retire in 2045, then you can choose the "Target Retirement Fund 2045".
Basically what they do is, they adjust the stocks and bonds mix depending on our retirement year.
It will have higher equity % when we have long time for retirement.
As we approach the retirement year, the percentage of Bonds in the fund will keep increasing.
So that, market volatility will have minimal impact on our portfolio after retirement.
So by default, choosing a target retirement fund is better option.
We can expect a return of 6-8% on average from this one.
If you would like to be little more aggressive than this, then you can invest 100% on S&P 500 Index fund or in Total Stock market index fund until you reach 50.
After you reach 50, you need to reduce the equity exposure and add bond exposure as you see fit.
Other than these, your 401K plans might have funds like smallcap, midcap, energy, International etc. Just ignore them.
May be you can consider just the International for a small %.
But in Today's world, companies like Microsoft, Google, Amazon etc. that are in S&P500 index are already International companies.
So in my opinion, we do not need a separate International exposure. Other than this, other funds are not required at all.
Some 401K plans offer self directed brokerage option as well.
Our 401K will be linked to a brokerage account and we will get option to buy ETFs or individual stocks depending on the plan.
If you ask me, it is better to avoid that. There is no reason for us to take any risk with 401K. Just stick to Index funds.
That is all there to a 401K. We will look into IRA in the next episode. Thank You.