The “Secret” Wealth Builder in Your 401K
The 401K is a great tool for building wealth. And depending on how your company runs their 401K plan, you could have a “secret” wealth creation tool in there. Now, it obviously isn’t a “secret”, however, it is a little know piece of a 401K plan. For the purposes of this article, we will use the updated 2024 contribution numbers. Let’s breakdown the three parts of a typical 401K, and the differences between the three.
Part One: Traditional
The traditional portion of the 401K is the part that most people associate with a 401K. If you receive a company match, this is most likely the portion that receives that company match. This is the area where contributions are made pre-tax, and taxed at ordinary income when you withdraw money. If you were to move the money out of a 401K plan, you could move it to a traditional IRA and not create a taxable event if it transfers in 90 days. The other area of note for the traditional is the RMDs. These are Required Minimum Distributions that start at age 73. Essentially, you haven’t paid taxes on it yet, so the government is making sure you do that. The max contribution in 2024 is $23,000 with a possible $7500 in catch up contributions.
Part Two: Roth
The Roth portion is an area that I see is very misunderstood. People typically know that if they use this option, they can take the money out tax free. This is true; however, this is not the portion of the 401K that will typically receive the company match. It is possible that you contribute 5% to your Roth 401K and your company matches in the traditional account. Another misconception that I see with Roth 401K, is that it has nothing to do with your ability to contribute to a Roth IRA. They are separate accounts. In 2024 with the updated numbers, you could technically invest $7,000 into a Roth IRA, and $23,000 into a Roth 401K.
Part Three: After-Tax
This is the “secret” that goes unused. A 401K plan is maxed out at $69,000 in total contributions, not including the $7500 catch-up. So, if you invest $23,000 in the traditional, and another $23,000 in Roth, you have an additional $23,000 you can contribute. This $23,000 would be contributed to the “After-Tax” 401K. This After-Tax portion has some complexities and is not offered in every 401K plan, please consult with an investment advisor representative before making any decisions. So, how does it work? Let’s look at a quick example. If we invest $23,000 after maxing out the other two, and it grows to $25,000 at the end of the year, we can roll the initial $23,000 investment into a Roth IRA. This means if we can contribute to all three, a Roth IRA, a Roth 401K, and After-Tax, we can see a total of $53,000 of tax-free investment contributions in one year. That additional $2000 of growth could also be rolled into a traditional IRA.
In closing, the After-Tax subaccount is a wealth building weapon if used properly. Once again, it can get very complex when dealing with this, as well as the timing of it. Before you make any decisions that might be costly, consult with a professional. And as always thanks for reading!