Confused: After-tax 401k contributions vs excess deferral

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Topic Author
investor4life
Posts: 528
Joined: Fri Oct 08, 2010 9:45 am

Confused: After-tax 401k contributions vs excess deferral

Post by investor4life »

The situation

DW has exceeded the 19.5K IRS annual contribution limit on her employer-sponsored 401k plan for this year. The plan is administered by Fidelity. According to Fidelity this is allowed; the excess is treated as an after-tax contribution and earnings grow tax-deferred until withdrawal (LINK).

But then we also came across info. on excess deferrals and how that can be bad as it may result in double-taxation (once at contribution and then at withdrawal). (LINK)

Question 1: Could someone clarify the distinction (if any) between these two things? We are confused.

Fidelity does give (on NetBenefits) three options to choose how contributions beyond the IRS limit should be treated.
1. Apply all to after-tax (default). Gets employer match.
2. Apply to after-tax to the extent needed to maximize employer match
3. Don't apply to after-tax (no after-tax contributions made).

The employer pays the match on a certain percentage of the eligible annual pay and does so in a lump sum, rather than per pay period (so we don't have to have a contribution every pay-period to avail of the full match).

We are thinking of going with option 3 over option 1, mainly to keep things simple. The 19.5K pre-tax contribution is enough to get the full employer match so option 2 doesn't seem necessary.

Question 2: Are we thinking about these options correctly?

Thank you.
sailaway
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Joined: Fri May 12, 2017 1:11 pm

Re: Confused: After-tax 401k contributions vs excess deferral

Post by sailaway »

Those are the contributions talked about for the mega backdoor Roth. To take advantage of that, you either need to have in plan rollover to Roth or the ability to do in service withdrawals to Roth. If you can do this second step, go for that match! It is pretty rare to get a match on these after tax contributions.

Excess contributions basically means your plan does not allow for these after tax contributions or you have exceeded even the higher limit.
marcopolo
Posts: 8446
Joined: Sat Dec 03, 2016 9:22 am

Re: Confused: After-tax 401k contributions vs excess deferral

Post by marcopolo »

investor4life wrote: Tue Oct 19, 2021 10:00 pm The situation

DW has exceeded the 19.5K IRS annual contribution limit on her employer-sponsored 401k plan for this year. The plan is administered by Fidelity. According to Fidelity this is allowed; the excess is treated as an after-tax contribution and earnings grow tax-deferred until withdrawal (LINK).

But then we also came across info. on excess deferrals and how that can be bad as it may result in double-taxation (once at contribution and then at withdrawal). (LINK)

Question 1: Could someone clarify the distinction (if any) between these two things? We are confused.

Fidelity does give (on NetBenefits) three options to choose how contributions beyond the IRS limit should be treated.
1. Apply all to after-tax (default). Gets employer match.
2. Apply to after-tax to the extent needed to maximize employer match
3. Don't apply to after-tax (no after-tax contributions made).

The employer pays the match on a certain percentage of the eligible annual pay and does so in a lump sum, rather than per pay period (so we don't have to have a contribution every pay-period to avail of the full match).

We are thinking of going with option 3 over option 1, mainly to keep things simple. The 19.5K pre-tax contribution is enough to get the full employer match so option 2 doesn't seem necessary.

Question 2: Are we thinking about these options correctly?

Thank you.
What are you trying to accomplish?

If your goal is to just get the maximum employer match, and doing the $19.5k of pre-tax accomplishes that, then option 3 would work fine.

If your goal is to maximize how much you put into tax-advantaged accounts, option 1 would accomplish that.

Since your pre-tax already gets you max matching, option 2 does not really apply to you at all.
Once in a while you get shown the light, in the strangest of places if you look at it right.
marcopolo
Posts: 8446
Joined: Sat Dec 03, 2016 9:22 am

Re: Confused: After-tax 401k contributions vs excess deferral

Post by marcopolo »

sailaway wrote: Tue Oct 19, 2021 10:08 pm Those are the contributions talked about for the mega backdoor Roth. To take advantage of that, you either need to have in plan rollover to Roth or the ability to do in service withdrawals to Roth. If you can do this second step, go for that match! It is pretty rare to get a match on these after tax contributions.

Excess contributions basically means your plan does not allow for these after tax contributions or you have exceeded even the higher limit.
If, I understood the OP properly, there would not be any matching on the after-tax contributions, already captured max matching by the pre-tax contributions. But, still useful to do to maximize tax-advantaged space.
Once in a while you get shown the light, in the strangest of places if you look at it right.
Topic Author
investor4life
Posts: 528
Joined: Fri Oct 08, 2010 9:45 am

Re: Confused: After-tax 401k contributions vs excess deferral

Post by investor4life »

sailaway wrote: Tue Oct 19, 2021 10:08 pm Those are the contributions talked about for the mega backdoor Roth. To take advantage of that, you either need to have in plan rollover to Roth or the ability to do in service withdrawals to Roth. If you can do this second step, go for that match! It is pretty rare to get a match on these after tax contributions.

Excess contributions basically means your plan does not allow for these after tax contributions or you have exceeded even the higher limit.
Thanks. I don't have a mega backdoor Roth and I don't think the links I gave were talking of that (but maybe I am wrong).
Topic Author
investor4life
Posts: 528
Joined: Fri Oct 08, 2010 9:45 am

Re: Confused: After-tax 401k contributions vs excess deferral

Post by investor4life »

marcopolo wrote: Tue Oct 19, 2021 10:13 pm
investor4life wrote: Tue Oct 19, 2021 10:00 pm The situation

DW has exceeded the 19.5K IRS annual contribution limit on her employer-sponsored 401k plan for this year. The plan is administered by Fidelity. According to Fidelity this is allowed; the excess is treated as an after-tax contribution and earnings grow tax-deferred until withdrawal (LINK).

But then we also came across info. on excess deferrals and how that can be bad as it may result in double-taxation (once at contribution and then at withdrawal). (LINK)

Question 1: Could someone clarify the distinction (if any) between these two things? We are confused.

Fidelity does give (on NetBenefits) three options to choose how contributions beyond the IRS limit should be treated.
1. Apply all to after-tax (default). Gets employer match.
2. Apply to after-tax to the extent needed to maximize employer match
3. Don't apply to after-tax (no after-tax contributions made).

The employer pays the match on a certain percentage of the eligible annual pay and does so in a lump sum, rather than per pay period (so we don't have to have a contribution every pay-period to avail of the full match).

We are thinking of going with option 3 over option 1, mainly to keep things simple. The 19.5K pre-tax contribution is enough to get the full employer match so option 2 doesn't seem necessary.

Question 2: Are we thinking about these options correctly?

Thank you.
What are you trying to accomplish?

If your goal is to just get the maximum employer match, and doing the $19.5k of pre-tax accomplishes that, then option 3 would work fine.

If your goal is to maximize how much you put into tax-advantaged accounts, option 1 would accomplish that.

Since your pre-tax already gets you max matching, option 2 does not really apply to you at all.
Thanks. That is our thinking as well. Our goal is to maximize the match and the pre-tax does it. Would rather not complicate things with a separate after-tax component to deal with (especially since it'd be only a couple grand and a tiny fraction of the overall retirement portfolio).
TropikThunder
Posts: 3918
Joined: Sun Apr 03, 2016 5:41 pm

Re: Confused: After-tax 401k contributions vs excess deferral

Post by TropikThunder »

investor4life wrote: Tue Oct 19, 2021 10:00 pm Question 1: Could someone clarify the distinction (if any) between these two things? We are confused.
Excess deferrals are almost entirely due to having changed employers mid-year since modern payroll systems are set up to stop people at the elective deferral limit of (currently) $19,500 plus catch-up of eligible. Once you hit that amount at one employer, deferrals are supposed to end that year - full stop. It’s a huge headache for a company to fix an excess deferral, which is why they have hard caps on it via payroll.

However if you change employers, employer B won’t know how much you contributed to employer A and you can end up contributing over the annual deferral limit in aggregate without either employer seeing it as an overage. That’s where the eventual double taxation will come from since you can’t deduct any amount over $19,500 (taxable on the way in). The custodian also has no way to segregate the excess, so those amounts (and their earnings) will also be taxable when withdrawn in the future (taxable on the way out).

“After-tax” deferrals are what posters here have referred to re: the MBR. If your plan allows after-tax deferrals (most don’t) then they won’t have the $19,500 hard cap and will let you keep going up to the final cap at ~$58,000 or so.
placeholder
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Joined: Tue Aug 06, 2013 12:43 pm

Re: Confused: After-tax 401k contributions vs excess deferral

Post by placeholder »

It sounds like what I had at megacorp where when you hit the deferral limit further contributions went into after tax which I could roll out to roth ira.
Topic Author
investor4life
Posts: 528
Joined: Fri Oct 08, 2010 9:45 am

Re: Confused: After-tax 401k contributions vs excess deferral

Post by investor4life »

TropikThunder wrote: Tue Oct 19, 2021 11:13 pm
investor4life wrote: Tue Oct 19, 2021 10:00 pm Question 1: Could someone clarify the distinction (if any) between these two things? We are confused.
Excess deferrals are almost entirely due to having changed employers mid-year since modern payroll systems are set up to stop people at the elective deferral limit of (currently) $19,500 plus catch-up of eligible. Once you hit that amount at one employer, deferrals are supposed to end that year - full stop. It’s a huge headache for a company to fix an excess deferral, which is why they have hard caps on it via payroll.

However if you change employers, employer B won’t know how much you contributed to employer A and you can end up contributing over the annual deferral limit in aggregate without either employer seeing it as an overage. That’s where the eventual double taxation will come from since you can’t deduct any amount over $19,500 (taxable on the way in). The custodian also has no way to segregate the excess, so those amounts (and their earnings) will also be taxable when withdrawn in the future (taxable on the way out).

“After-tax” deferrals are what posters here have referred to re: the MBR. If your plan allows after-tax deferrals (most don’t) then they won’t have the $19,500 hard cap and will let you keep going up to the final cap at ~$58,000 or so.
Thanks for the detailed response; very helpful. The last paragraph of your reply is what applies in our case. I did not know about the mega backdoor Roth but just read up on it. And my apologies to @sailaway for not understanding that related post.
sailaway
Posts: 8218
Joined: Fri May 12, 2017 1:11 pm

Re: Confused: After-tax 401k contributions vs excess deferral

Post by sailaway »

investor4life wrote: Wed Oct 20, 2021 10:27 am
TropikThunder wrote: Tue Oct 19, 2021 11:13 pm
investor4life wrote: Tue Oct 19, 2021 10:00 pm Question 1: Could someone clarify the distinction (if any) between these two things? We are confused.
Excess deferrals are almost entirely due to having changed employers mid-year since modern payroll systems are set up to stop people at the elective deferral limit of (currently) $19,500 plus catch-up of eligible. Once you hit that amount at one employer, deferrals are supposed to end that year - full stop. It’s a huge headache for a company to fix an excess deferral, which is why they have hard caps on it via payroll.

However if you change employers, employer B won’t know how much you contributed to employer A and you can end up contributing over the annual deferral limit in aggregate without either employer seeing it as an overage. That’s where the eventual double taxation will come from since you can’t deduct any amount over $19,500 (taxable on the way in). The custodian also has no way to segregate the excess, so those amounts (and their earnings) will also be taxable when withdrawn in the future (taxable on the way out).

“After-tax” deferrals are what posters here have referred to re: the MBR. If your plan allows after-tax deferrals (most don’t) then they won’t have the $19,500 hard cap and will let you keep going up to the final cap at ~$58,000 or so.
Thanks for the detailed response; very helpful. The last paragraph of your reply is what applies in our case. I did not know about the mega backdoor Roth but just read up on it. And my apologies to @sailaway for not understanding that related post.
No problem - it takes time to digest all of this. It took me quite awhile to convince DH to participate. Turns out he had noticed that he had access to after tax deferrals, but didn't know about the converting part, so it didn't seem like such a great idea.
aristotelian
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Joined: Wed Jan 11, 2017 7:05 pm

Re: Confused: After-tax 401k contributions vs excess deferral

Post by aristotelian »

The first link does not say anything about excess contributions. It is referring to after-tax contributions which are allowed by some plans.

Can you say how this overcontribution occurred? Generally your payroll service will cap you at the IRS limit.

I would call Fidelity to get the excess contribution corrected. If you have the option to convert an excess contribution to after-tax, that only makes sense if you have the ability to convert it to Roth. Otherwise, any gains will eventually be taxable as income. You would be better off taking the return-of-contribution so gains would be subject to lower capital gains tax.
TropikThunder
Posts: 3918
Joined: Sun Apr 03, 2016 5:41 pm

Re: Confused: After-tax 401k contributions vs excess deferral

Post by TropikThunder »

aristotelian wrote: Wed Oct 20, 2021 10:43 am The first link does not say anything about excess contributions. It is referring to after-tax contributions which are allowed by some plans.

Can you say how this overcontribution occurred? Generally your payroll service will cap you at the IRS limit.

I would call Fidelity to get the excess contribution corrected. If you have the option to convert an excess contribution to after-tax, that only makes sense if you have the ability to convert it to Roth. Otherwise, any gains will eventually be taxable as income. You would be better off taking the return-of-contribution so gains would be subject to lower capital gains tax.
It’s not an excess contribution, it’s after-tax (which OP says their plan allows). No need to remove it. As I pointed out earlier, if the plan allows after-tax contributions then they won’t stop deferrals at the elective deferral limit. OP was just confused about the terminology.
Topic Author
investor4life
Posts: 528
Joined: Fri Oct 08, 2010 9:45 am

Re: Confused: After-tax 401k contributions vs excess deferral

Post by investor4life »

TropikThunder wrote: Wed Oct 20, 2021 12:07 pm
aristotelian wrote: Wed Oct 20, 2021 10:43 am The first link does not say anything about excess contributions. It is referring to after-tax contributions which are allowed by some plans.

Can you say how this overcontribution occurred? Generally your payroll service will cap you at the IRS limit.

I would call Fidelity to get the excess contribution corrected. If you have the option to convert an excess contribution to after-tax, that only makes sense if you have the ability to convert it to Roth. Otherwise, any gains will eventually be taxable as income. You would be better off taking the return-of-contribution so gains would be subject to lower capital gains tax.
It’s not an excess contribution, it’s after-tax (which OP says their plan allows). No need to remove it. As I pointed out earlier, if the plan allows after-tax contributions then they won’t stop deferrals at the elective deferral limit. OP was just confused about the terminology.
Right--confused is putting it mildly :D

DW's employer (a megacorp) wasn't good about conveying this info about after-tax contributions being allowed. In previous years, we'd manually adjust the contribution towards the end of the year to meet the IRS limit (not even realizing we could go over it if we so desired). This year it slipped my mind until last night and at that point we'd already gone over the limit (by about a hundred bucks).

In any case, thanks all for the quick input (this forum is amazing!). As I mentioned earlier, we will go with option 3 at Fidelity (options mentioned in original post) to keep things simple.
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