After-tax 401(k) vs. taxable account

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garg33
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After-tax 401(k) vs. taxable account

Post by garg33 »

Hi Bogleheads,

My situation:
- maxed out traditional IRA
- maxed out traditional 401(k)
- some money left over to invest

My company offers me the option, after maxing out traditional pre-tax 401(k) contributions ($16,500), to then make additional after-tax 401(k) contributions up to the IRS max. of $49,000. The question is, between this and investing in a taxable account, which is better?

From my research, I have come up with the following points...

After-tax 401(k)
- investments grow tax-deferred
- at retirement age, withdrawal of contributions is not taxed and gains are taxed as ordinary income

Taxable accounts
- investments grow taxed
- contributions (obviously) not taxed beyond normal income taxes, gains taxed as capital gains

I seek the help of you experts...what do I need to consider in determining whether it'd be better to invest my leftover money after-tax in the 401(k) or in a taxable account? Do the benefits of tax-deferred growth in the 401(k) compensate for the higher withdrawal tax rate, or not?

Thanks!
cliffedelgado
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Post by cliffedelgado »

This doesn't answer your question, but could be another advantage of the after-tax 401k.

Check if your plan allows in-service withdrawals prior to age 59. You may be able to roll over the after-tax 401k amounts into a Roth IRA while still employed.
xerty24
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Post by xerty24 »

How long are you planning on staying at this job? As cliff says, you can convert these after-tax contributions to your Roth IRA either while employed (if allowed), or after you quit (otherwise).

It's true that after-tax money that stays in a plan growing tax-deferred but eventually taxed is a pretty good benefit. I would say that broadly this is only worthwhile if you need more IRA/401k space to hold fixed income assets. Remember that for stocks you can get deferral by just not selling and you wouldn't really want to hold stocks in an after-tax 401k account since it would be converting long-term captial gains into ordinary income in the process. For stuff like bonds were they were taxed as ordinary to begin with, this is no worse and the tax deferral is considerably better (than taxable).
Topic Author
garg33
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Post by garg33 »

Cool, thanks for the info! Not planning to leave my job any time soon, but I'll check if in-service withdrawals are allowed for the Roth IRA conversion. How does the conversion work? I am guessing tax-free conversion on contributions and I'll need to pay income taxes on converted gains at the time of conversion, or is it more complicated than that?

Thanks also for the good point about fixed income space vs. stocks space. Right now I'm right about at my target asset allocation, so I'll just be scaling everything up proportionally with the new money. So I could put the money for more bonds/REITs in the after-tax 401(k) and the money for total-U.S. in my taxable account.

On the scale of tax efficient fund placement, international stock funds fall somewhere between total-U.S. and bonds in terms of efficiency, right? Would it make more sense to put those in the after-tax 401(k) or the taxable account? Right now I just have VGTSX (Vanguard Total International Index) in my 401(k), so I could get more of that. If it'd be better to put international stocks in the taxable account would it be better to buy the tax-managed international fund?

Thanks again for the advice.
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garg33
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Post by garg33 »

Did I just make up the whole thing about international funds like VGTSX being less tax-efficient than total-U.S. and inappropriate for taxable accounts? :)

The Wiki suggests I am wrong...I tried to post a link to the "Principles of Tax-Efficient Fund Placement" page but I am forbidden as a new member.
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Kevin M
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Post by Kevin M »

This is similar to a non-deductible IRA, except for the higher contribution limit of the 401k, and possibly higher fund costs. tfb has a blog post on this, and a spreadsheet to help with the decision: http://thefinancebuff.com/2008/09/a-non ... or-me.html. One thing not included in tfb's model that might be relevant here is the higher cost (e.g., expense ratio, turnover) that you might have to pay for funds in your 401k. If you have good low-cost choices in your 401k, then that's not an issue.

With respect to international funds, as mentioned in the wiki (which apparently you've read), you lose the foreign tax credit if held in tax-advantaged accounts, so I'd prefer to hold international in taxable.
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garg33
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Post by garg33 »

I am very lucky to have Vanguard as our 401(k) administrator so the fund choices are great. Thanks for the link, I will mess around with the spreadsheet.
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garg33
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Post by garg33 »

Unrelated question: if international funds like VGTSX are already tax efficient, why is there a tax managed version?
555
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Post by 555 »

I agree with xerty24. If you are going to use nondeductible-traditional space for any amount of time, you should definitely not holds any stocks there. None. Use this space purely for bonds, while keeping your asset allocation as desired.

If there is any way you can move the assets into Roth space, that is always better.

Also be aware of how the cost basis is `prorated' when you withdraw (I'll let others elaborate).
xerty24 wrote:How long are you planning on staying at this job? As cliff says, you can convert these after-tax contributions to your Roth IRA either while employed (if allowed), or after you quit (otherwise).

It's true that after-tax money that stays in a plan growing tax-deferred but eventually taxed is a pretty good benefit. I would say that broadly this is only worthwhile if you need more IRA/401k space to hold fixed income assets. Remember that for stocks you can get deferral by just not selling and you wouldn't really want to hold stocks in an after-tax 401k account since it would be converting long-term captial gains into ordinary income in the process. For stuff like bonds were they were taxed as ordinary to begin with, this is no worse and the tax deferral is considerably better (than taxable).
xerty24
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Post by xerty24 »

555 wrote:Also be aware of how the cost basis is `prorated' when you withdraw (I'll let others elaborate).
Not if you do a direct-to-Roth IRA rollover and conversion straight from your qualified plan. If you move it to a tIRA first and then convert it, yes, you may have to worry about tIRA basis considerations effecting the benefit of the conversion. That said, putting an extra ~$35K into a Roth IRA is pretty huge so those considerations just mean it'll be a little more work/hassle and tax bookkeeping, not that you generally wouldn't still want to convert.
Wagnerjb
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Post by Wagnerjb »

555 wrote:Also be aware of how the cost basis is `prorated' when you withdraw (I'll let others elaborate).
I also agree with Xerty's comments (in his first post). The issue with proration is that you want to be able to cherry pick your accounts in retirement. You want to fill up the lower tax brackets every year, so this is best accomplished by withdrawing from 100% taxable funds (such as IRA or 401k). In some circumstances you may want to avoid going into the next higher tax bracket. To do this, you will withdraw after-tax money. If your after-tax money (in the 401k) is commingled with pre-tax earnings on those funds, you may not be able to cherry pick the after tax funds only. That would be costly, and that is the reason why I won't contribute non-deductible money to my 401k plan.

With after-tax funds in a taxable account, you can cherry pick. You can find specific lots with the least amount of gain first. Or if - like many of us with taxable accounts - you have a wealth of tax losses....you can pick any asset you want to sell. Even with no tax losses accumulated, you can sell a fund with a 30% gain and end up paying tax that amounts to less than 5% of the proceeds.

Best wishes.
Andy
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grabiner
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Re: After-tax 401(k) vs. taxable account

Post by grabiner »

garg33 wrote:I seek the help of you experts...what do I need to consider in determining whether it'd be better to invest my leftover money after-tax in the 401(k) or in a taxable account? Do the benefits of tax-deferred growth in the 401(k) compensate for the higher withdrawal tax rate, or not?
An after-tax 401(k) is equivalent to a non-deductible IRA. If you would be holding stocks, they would be better in a taxable account; most of the stock gains are already tax-deferred, and gains in a taxable account are taxed at a lower rate. If you would be holding bonds in the 401(k), it's a close decision, depending on the expenses; the tax-deferral is useful, but the tax cost of holding municipal bonds in a taxable account is less than the tax on corporate bonds. If you would be holding tax-inefficient stocks in the 401(k) such as REITs, then the 401(k) is worthwhile; Bogleheads even recommend using Vanguard's variable annuity if you need to hold REITs in an all-taxable portfolio.
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grabiner
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Post by grabiner »

garg33 wrote:Did I just make up the whole thing about international funds like VGTSX being less tax-efficient than total-U.S. and inappropriate for taxable accounts? :)

The Wiki suggests I am wrong...I tried to post a link to the "Principles of Tax-Efficient Fund Placement" page but I am forbidden as a new member.
The reason that international funds are more tax-efficient is the foreign tax credit. If a foreign country withholds tax on dividends, you don't get the withheld tax, but in a taxable account, you can usually take that tax as a credit against your own taxes. This is usually worth about 0.15%.
Unrelated question: if international funds like VGTSX are already tax efficient, why is there a tax managed version?
It made sense at the time. Total International used to be a fund-of-funds (holding Europe, Pacific, and Emerging Markets separately) and was thus ineligible for the foreign tax credit. Even now, Tax-Managed International has 100% qualified dividends, which the other international index funds do not have, and it may be managed to reduce its dividend yield slightly. Until Tax-Managed International adds Admiral shares, fund investors starting out now in a taxable account would be better with Total International than with piecing a portfolio together from three funds (Tax-Managed International, Emerging Markts, FTSE All-World Ex-US Small-Cap); ETF investors might come out slightly ahead with the three separate ETFs.
Wiki David Grabiner
Default User BR
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Post by Default User BR »

xerty24 wrote:
555 wrote:Also be aware of how the cost basis is `prorated' when you withdraw (I'll let others elaborate).
Not if you do a direct-to-Roth IRA rollover and conversion straight from your qualified plan. If you move it to a tIRA first and then convert it, yes, you may have to worry about tIRA basis considerations effecting the benefit of the conversion.
I'm not sure what you mean. Are you referring to pro-rata due to existing traditional IRAs with taxable money, or the taxable earnings that must accompany after-tax distributions from a qualified plan? I'm unconvinced that some of the methods proposed really get around pro-rata.

At any rate, there is an IRS bulletin that covers some of this information:

http://www.irs.gov/irb/2009-39_IRB/ar14.html



Brian
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garg33
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Post by garg33 »

Thanks a lot to everyone for the great info! To recap, my plan going forward is to put new purchases of tax-inefficient assets (bond funds, REITs) in the after-tax 401(k) and relatively tax-efficient assets (total U.S./international stock funds) in my taxable account. Looks like no in-service withdrawals are allowed, so no extra Roth space for me...oh well. :)
xerty24
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Post by xerty24 »

Default User BR wrote:
xerty24 wrote:
555 wrote:Also be aware of how the cost basis is `prorated' when you withdraw (I'll let others elaborate).
Not if you do a direct-to-Roth IRA rollover and conversion straight from your qualified plan. If you move it to a tIRA first and then convert it, yes, you may have to worry about tIRA basis considerations effecting the benefit of the conversion.
I'm not sure what you mean. Are you referring to pro-rata due to existing traditional IRAs with taxable money, or the taxable earnings that must accompany after-tax distributions from a qualified plan? I'm unconvinced that some of the methods proposed really get around pro-rata.
My point was that the Roth conversion of a tIRA looks at prorata basis across all IRAs, but the Roth conversion of a qualified plan, when done in conjunction with a rollover, only looks that plan's assets. In the case of an after-tax to Roth conversion, this means that you pay tax on the after-tax portion's earnings (if any), but there is no effect from other IRAs you may hold. I know there's a technical point about the after-tax portion's earnings and ordering of withdrawals from the qualified plan, but in cases where you can do an inservice withdrawal, this is small enough not to be of practical importance.
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Post by Wagnerjb »

xerty24 wrote:
Default User BR wrote:
xerty24 wrote:
555 wrote:Also be aware of how the cost basis is `prorated' when you withdraw (I'll let others elaborate).
Not if you do a direct-to-Roth IRA rollover and conversion straight from your qualified plan. If you move it to a tIRA first and then convert it, yes, you may have to worry about tIRA basis considerations effecting the benefit of the conversion.
I'm not sure what you mean. Are you referring to pro-rata due to existing traditional IRAs with taxable money, or the taxable earnings that must accompany after-tax distributions from a qualified plan? I'm unconvinced that some of the methods proposed really get around pro-rata.
My point was that the Roth conversion of a tIRA looks at prorata basis across all IRAs, but the Roth conversion of a qualified plan, when done in conjunction with a rollover, only looks that plan's assets. In the case of an after-tax to Roth conversion, this means that you pay tax on the after-tax portion's earnings (if any), but there is no effect from other IRAs you may hold. I know there's a technical point about the after-tax portion's earnings and ordering of withdrawals from the qualified plan, but in cases where you can do an inservice withdrawal, this is small enough not to be of practical importance.
It sounds like you are describing a pretty big "cost" to make the pro-rata issue go away. How about people who don't want to convert to a Roth? They have both pretax and after-tax money in their 401k, and (unless they pay the price to convert) they end up with a mishmash of pre and post tax funds in the 401k (or IRA if they roll over). That's the worst scenario if you want to manage your income taxes in retirement.

Best wishes.
Andy
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Post by Default User BR »

xerty24 wrote:My point was that the Roth conversion of a tIRA looks at prorata basis across all IRAs, but the Roth conversion of a qualified plan, when done in conjunction with a rollover, only looks that plan's assets. In the case of an after-tax to Roth conversion, this means that you pay tax on the after-tax portion's earnings (if any), but there is no effect from other IRAs you may hold.
I'm not so sure. Pub 590 contains the following:
Unlike a conversion of a traditional IRA to a Roth IRA, rollovers from employer plans to Roth IRAs are not reported on Form 8606. However, for 2010, a rollover from an employer plan to a Roth IRA will be reported on Form 8606.
http://www.irs.gov/publications/p590/ch ... 1000231036

This situation, to me, got a lot more confusing. I think it's still best, if you can arrange it, to have no deductible IRA amounts at all.



Brian
xerty24
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Post by xerty24 »

Wagnerjb wrote:It sounds like you are describing a pretty big "cost" to make the pro-rata issue go away. How about people who don't want to convert to a Roth? They have both pretax and after-tax money in their 401k, and (unless they pay the price to convert) they end up with a mishmash of pre and post tax funds in the 401k (or IRA if they roll over). That's the worst scenario if you want to manage your income taxes in retirement.
You can roll your pretax and your after-tax portions separately, which avoids most of the problems you're describing. The only cost is associated with the earnings on the after-tax portion during the time it's in the plan but before you convert. For example, if you were going to work for 3 years and quit (at a firm that didn't allow inservice withdrawals), you'd have to pay tax at conversion on 3 years of earnings on your aftertax portion as a "cost". However you'd have had those same earnings in a taxable account instead, and though the taxable account will be able to delay realization for as long as you're willing to hold, the fact that in the after-tax case all subsequent earnings after Roth conversion would be tax-free would be a pretty big benefit in most circumstances involving retirement savings.
Default User BR wrote:
xerty24 wrote:My point was that the Roth conversion of a tIRA looks at prorata basis across all IRAs, but the Roth conversion of a qualified plan, when done in conjunction with a rollover, only looks that plan's assets. In the case of an after-tax to Roth conversion, this means that you pay tax on the after-tax portion's earnings (if any), but there is no effect from other IRAs you may hold.
I'm not so sure. Pub 590 contains the following:
for 2010, a rollover from an employer plan to a Roth IRA will be reported on Form 8606.
This situation, to me, got a lot more confusing. I think it's still best, if you can arrange it, to have no deductible IRA amounts at all.
I invite you to read the draft of 2010 8606. You will clearly see that Part II (Conversions of IRAs to Roth IRAs) references Part I and your basis in other IRA accounts, while Part III (Rollover of Qualified Plans to Roth IRAs) only references the basis in the amount rolled over from the plan. Assuming they don't drastically change anything, it's clear that the approach I described avoids commingling of all pretax monies aside from possibly earnings on the after-tax 401k balance.
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Post by Default User BR »

xerty24 wrote:You will clearly see that Part II (Conversions of IRAs to Roth IRAs) references Part I and your basis in other IRA accounts, while Part III (Rollover of Qualified Plans to Roth IRAs) only references the basis in the amount rolled over from the plan. Assuming they don't drastically change anything, it's clear that the approach I described avoids commingling of all pretax monies aside from possibly earnings on the after-tax 401k balance.
Ok. That helps clear some of my uncertainty. It's still a concern if there is a significant amount of earnings. It would be best to clear out the after-tax as soon as possible.



Brian
xerty24
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Post by xerty24 »

Default User BR wrote:It's still a concern if there is a significant amount of earnings. It would be best to clear out the after-tax as soon as possible.
There's no question that rolling out and converting your after-tax savings ASAP is the best option. That said, getting to contribute meaningfully higher amounts to a Roth IRA is sufficiently good for those with a long time to retirement that even having to hold after-tax assets for several years before conversion (with potentially with associated taxes on earnings) is still likely a better choice than taxable. YMMV - run the numbers on your likely investment assets and time at the current job to see if it makes sense.
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