After-Tax Investment Considerations

Some individuals have the ability to contribute after-tax amounts to their employer-sponsored plans such as a tax-deferred 401k or a defined benefit pension. Generally, since these amounts are after-tax, the contributions start adding up to a sizable amount known as basis. Basis is simply the amount of after-tax money put into these accounts that is not taxed when it’s withdrawn. However, any earnings on the basis are taxable.

Individuals considering contributing after-tax amounts to the above plans may also consider if it makes sense to contribute to a non-qualified brokerage account. Like the aforementioned employer-sponsored plans, contributions to a non-qualified brokerage account are made with after-tax dollars, thus they can build a sizable basis – which is not taxed when withdrawn. Also, like the above employer-sponsored accounts, any earnings are subject to taxation. The major difference is in the way the earnings from the non-qualified account are taxed.

Earnings on after-tax contributions to employer-sponsored plans are taxed at the individual’s ordinary income tax rate. However, earnings on after-tax contributions to a non-qualified brokerage account are taxed more favorably as long-term capital gains (assuming they are held for longer than one year). Although the non-qualified account may seem like the way to go, there are a number of items to consider before choosing which account to place your after-tax money.

One area to explore is how retirement income is taxed in your state. Some states such as Illinois currently do not tax retirement income. Thus, the earnings from the after-tax 401k or pension contributions would not be taxed at the state level, only federally. Earnings from the non-qualified account would be taxed both at the state and federal level.

Additionally, consider the amount of risk the contributions are being exposed to in their plans. Most non-qualified brokerage account and employer-sponsored 401k risk is the responsibility of the individual or employee. However, some defined benefit pension plans bear all the investment risk while providing a nice crediting interest rate. Thus, if an employer-sponsored defined benefit pension allows after-tax contributions, credits interest at 7.5% (accurate as of this writing for some pensions) and bears all of the investment risk, an individual may find that they are willing to pay a higher percentage in tax for the corresponding interest rate credit and transfer of investment risk.

Other considerations include the individual’s goals for the money at retirement and at death. For example, a 401k will have required minimum distributions (RMDs) at age 70 ½. Non-qualified brokerage accounts do not. Furthermore, most beneficiaries that inherit a 401k account must take RMDs based on the life expectancy of the beneficiary. Taxation is still at the ordinary income tax rate on earnings, but the after-tax amount still constitute basis. Beneficiaries of non-qualified brokerage accounts experience a change in their tax basis. In other words, the account value on the date of the account owner’s death becomes the beneficiary’s new tax basis. Thus, any earnings above that amount are taxed as long-term capital gains rates.

For defined benefit pensions, the beneficiary would be the spouse. At the death of the account owner, the spousal beneficiary would receive whatever annuity payout was agreed upon when the pension was initiated. However, if the employee was single or the spousal beneficiary dies; these payments cease. There’s no account balance to inherit or additional beneficiary to receive the pension.

The post After-Tax Investment Considerations appeared first on Getting Your Financial Ducks In A Row.

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jim@blankenshipfinancial.com (Jim Blankenship)

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