What Is an After-Tax Contribution?

An after-tax contribution is money paid into a retirement or investment account after income taxes on those earnings have already been deducted. When opening a tax-advantaged retirement account, an individual may choose to defer the income taxes owed until after retiring, if it is a traditional retirement account, or pay the income taxes in the year in which the payment is made, if it is a Roth retirement account.

Some savers, mostly those with higher incomes, may contribute after-tax income to a traditional account in addition to the maximum allowable pre-tax amount. They don’t get any immediate tax benefit. This commingling of pre-tax and post-tax money takes some careful accounting for tax purposes.

Understanding After-Tax Contributions

In order to encourage Americans to save toward their retirement years, the government offers several tax-advantaged retirement plans such as the 401(k) plan, offered by many companies to their employees, and the IRA, which anyone with earned income can open through a bank or a brokerage.

Most, but not all, people who open a retirement account can choose either of two main options:

• The traditional retirement account allows its owner to put “pre-tax” money in an investment account. That is, the money is not subject to income tax in the year it is paid in. The saver’s gross taxable income for that year is reduced by the amount of the contribution. The IRS will get its due when the account holder withdraws the money, presumably after retiring.
• The Roth account is the “after-tax” option. It allows the saver to pay in money after it is taxed. That is more of a hit to the person’s immediate take-home income. But after retirement, no further taxes are owed on the entire balance in the account. The Roth 401(k) option (referred to as a designated Roth option) is newer, and not all companies offer them to their employees. Earners above a set limit are not eligible to contribute to a Roth IRA account.

Post-Tax or Pre-Tax?

The post-tax Roth option offers the attraction of a retirement nest egg that is not subject to further taxes. It makes the most sense for those who believe they may be paying a higher tax rate in the future, either because of their expected retirement income or because they think taxes will go up.

In addition, money contributed post-tax can be withdrawn at any time without a fat IRS penalty being imposed. (The profits in the account are untouchable until the account holder is 59½.)

On the downside, the post-tax option means a smaller paycheck with every contribution into the account. The pre-tax or traditional option reduces the saver’s taxes owed for the year the contributions are made, and it is a smaller hit to current income.

The downside is, withdrawals from this type of retirement fund will be taxable income, whether it’s money that was paid in or profits the money earned.

After-Tax Contributions and Roth IRAs

A Roth IRA, by definition, is a retirement account in which the earnings grow tax-free as long as the money is held in the Roth IRA for at least five years. Contributions to a Roth are made with after-tax dollars, and as a result, they are not tax-deductible. However, you can withdraw the contributions in retirement tax-free.

Both post-tax and pre-tax retirement accounts have limits on how much can be contributed each year:

• The annual contribution limit for both Roth and traditional IRAs is $6,000 for tax year 2022 (increasing to $6,500 in 2023). Those aged 50 and over can deposit an additional catch-up contribution of $1,000.
• The contribution limit for Roth and traditional 401(k) plans is $20,500 for 2022 (increasing to $22,500 in 2023), plus $6,500 for those age 50 and above.

Early Withdrawal Tax Penalty

As noted, the money deposited in a post-tax or Roth account, but not any profits it earns, can be withdrawn at any time without penalty. The taxes have already been paid, and the IRS doesn’t care.

But if it’s a pre-tax or traditional account, any money withdrawn before age 59½ is fully taxable and subject to a hefty early withdrawal penalty.

An account holder who changes jobs can roll over the money into a similar account available at the new job without paying any taxes. The term “roll over” is meaningful. It means that the money goes straight from account to account and never gets paid into your hands. Otherwise, it can count as taxable income for that year.

Special Considerations

As noted above, there are limits to the amount of money that a saver can contribute each year to a retirement account. (Actually, you can have more than one account, or a post-tax and a pre-tax account, but the total contribution limits are the same.)

Withdrawals of after-tax contributions to a traditional IRA should not be taxed. However, the only way to make sure this does not happen is to file IRS Form 8606. Form 8606 must be filed for every year you make after-tax (non-deductible) contributions to a traditional IRA and for every subsequent year until you have used up all of your after-tax balance.

Since the funds in the account are separated into taxable and non-taxable components, figuring the tax due on the required distributions is more complicated than if the account holder had made only pre-tax contributions.

What Is After-Tax Income?

After-tax income is the net income after the deduction of all federal, state, and withholding taxes. After-tax income, also called income after taxes, represents the amount of disposable income that a consumer or firm has available to spend.

Understanding After-Tax Income

Most individual tax filers use some version of the IRS Form 1040 to calculate their taxable income, income tax due, and after-tax income. To calculate after-tax income, the deductions are subtracted from gross income. The difference is the taxable income, on which income taxes are due. After-tax income is the difference between gross income and the income tax due. 

Consider the following example: Abi Sample earns $30,000 and claims $10,000 in deductions, resulting in a taxable income of $20,000. Their federal income tax rate is 15%, making the income tax due $3,000. The after-tax income is $27,000, or the difference between gross earnings and income tax ($30,000 – $3,000 = $27,000).

Individuals can also account for state and local taxes when calculating after-tax income. When doing this, sales tax and property taxes are also excluded from gross income. Continuing with the above example, Abi Sample pays $1,000 in state income tax and $500 in municipal income tax resulting in an after-tax income of $25,500 ($27,000 – $1500 = $25,500).

Calculating After-Tax Income for Businesses

Computing after-tax income for businesses is relatively the same as for individuals. However, instead of determining gross income, enterprises begin by defining total revenues. Business expenses, as recorded on the income statement, are subtracted from total revenues producing the firm’s income. Finally, any other relevant deductions are subtracted to arrive at taxable income.

The difference between the total revenues and the business expenses and deductions is the taxable income, on which taxes will be due. The difference between the business’s income and the income tax due is the after-tax income.

After-Tax and Pretax Retirement Contributions

The terms after-tax and pretax income often refer to retirement contributions or other benefits. For example, if someone makes pretax contributions to a retirement account, those contributions are subtracted from their gross pay. After deductions are made to the gross salary amount, the employer will calculate payroll taxes.

Medicare contributions and Social Security payments are calculated on the difference after these deductions are taken from the gross salary amount. However, if the employee makes after-tax contributions to a retirement account, the employer applies taxes to the employee’s gross pay and then subtracts the retirement contributions from that amount.

What Was a 412(i) Plan?

A 412(i) plan was a defined-benefit pension plan that was designed for small business owners in the U.S. It was classified as a tax-qualified pension plan, so any amount that the owner contributed to it could immediately be taken as a tax deduction by the company. Guaranteed annuities or a combination of annuities and life insurance were the only things that could fund a 412(i) plan. The 412(i) plan was replaced by the 412(e)(3) plan after Dec. 31, 2007.

Understanding a 412(i) Plan

Notably, 412(i) plans were developed for small business owners who often found it difficult to invest in their company while trying to save for employees’ retirement. The 412(i) plan was unique in that it provided fully guaranteed retirement benefits.

An insurance company had to sponsor the 412(i) plan, and only insurance products like annuities and life insurance policies could fund it. Contributions to it provide the largest tax deduction possible.

An annuity is a financial product that an individual can purchase via a lump-sum payment or installments. The insurance company, in turn, pays the owner a fixed stream of payments at some point in the future. Annuities are primarily used as an income stream for retirees. 

Due to the large premiums that had to be paid into the plan each year, a 412(i) plan was not ideal for all small business owners. The plan tended to benefit small businesses that were more established and profitable.

For example, a startup that had gone through several rounds of funding would have been in a better position to create a 412(i) plan than one that was bootstrapped and/or had angel or seed funding.

These companies also often don’t generate enough free cash flow (FCF) to put away consistently for employees’ retirement. Instead, the founding team members often re-invest any profits or outside funding back into their product or service to generate new sales and make updates to their core offerings.

412(i) Plans and Compliance Issues

In August 2017, the Internal Revenue Service (IRS) identified 412(i) plans as being involved in various types of non-compliance. These also included abusive tax avoidance transaction issues. To help organizations with 412(i) plans come into compliance, the IRS developed the following survey. They asked:

• Do you have a 412(i) plan?
• If so, how do you fund this plan? (i.e., annuities, insurance contracts, or a combination?)
• What is the amount of the death benefit relative to the amount of retirement benefit for each plan participant?
• Have you had a listed transaction under Revenue Ruling 2004-20? If so, have you filed Form 8886, Reportable Transaction Disclosure Statement?
• Finally, who sold the annuities and/or insurance contracts to the sponsor?

A survey of 329 plans yielded the following:

• 185 plans referred for examination
• 139 plans deemed to be “compliance sufficient”
• Three plans under “current examination”
• One plan noted as “compliance verified” (meaning no further contact was necessary)
• One plan labeled as not a 412(i) plan

412(e)(3)

Due to the abuses of the 412(i) plan resulting in tax avoidance schemes, the Internal Revenue Service (IRS) moved the 412(i) provisions to 412(e)(3), effective for plans beginning after Dec. 31, 2007. 412(e)(3) functions similarly to 412(i), except that it is exempt from the minimum funding rule. According to the IRS, the requirements for 412(e)(3) are as follows:

• Plans must be funded exclusively by the purchase of a combination of annuities and life insurance contracts or individual annuities,
• Plan contracts must provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective),
• Benefits provided by the plan are equal to the benefits provided under each contract at normal retirement age under the plan and are guaranteed by an insurance carrier (licensed under the laws of a state to do business with the plan) to the extent premiums have been paid,
• Premiums payable under such contracts for the plan year, and all prior plan years, have been paid before lapse or there is a reinstatement of the policy,
• No rights under such contracts have been subject to a security interest at any time during the plan year, and
• No policy loans are outstanding at any time during the plan year

What Is Anti Money Laundering (AML)?

Anti money laundering (AML) refers to the web of laws, regulations, and procedures aimed at uncovering efforts to disguise illicit funds as legitimate income. Money laundering seeks to conceal crimes ranging from small-time tax evasion and drug trafficking to public corruption and the financing of groups designated as terrorist organizations.

AML legislation was a response to the growth of the financial industry, the lifting of international capital controls and the growing ease of conducting complex chains of financial transactions.

A high-level United Nations panel has estimated annual money laundering flows at $1.6 trillion, accounting for 2.7% of global GDP in 2020.

Understanding Anti Money Laundering (AML)

AML regulations in the U.S. have expanded from the 1970 Bank Secrecy Act’s requirement that banks report cash deposits of more than $10,000 to a complex regulatory framework requiring financial institutions to conduct due diligence on customers and to seek out and report suspicious transactions. The European Union and other jurisdictions have adopted similar measures.

Know Your Customer

For banks, compliance starts with verifying the identity of new clients, a process sometimes called Know Your Customer (KYC). In addition to establishing the customer’s identity, banks are required to understand the nature of a client’s activity and verify deposited funds are from a legitimate source.

The KYC process also requires banks and brokers to screen new customers against lists of crime suspects, individuals and companies under economic sanctions, and “politically exposed persons”—foreign public officials, their family members and close associates.

Money laundering can be divided into three steps:

• Deposit of illicit funds into the financial system
• Transactions designed to conceal the illicit origin of the funds, known as “layering”
• Use of laundered funds to acquire real estate, financial instruments or commercial investments

The KYC process aims to stop such schemes at the first deposit window.

Customer Due Diligence

Customer due diligence is integral to the KYC process, for example by ensuring the information a potential customer provides is accurate and legitimate. But it is also a constant process extending to customers old and new, and their transactions.

Customer due diligence requires ongoing assessment of the risk of money laundering posed by each client and the use of that risk-based approach to conduct closer due diligence for those identified as higher non-compliance risks. That includes identifying customers as they are added to sanctions and other AML lists.

According to the U.S. Treasury’s Financial Crimes Enforcement Network, the four core requirements of customer due diligence in the U.S. are:

• Identifying and verifying the customer’s identity
• Identifying and verifying the identity of beneficial owners with a stake of 25% or more in a company opening an account
• Understanding the nature and purpose of customer relationships to develop customer risk profiles
• Conducting ongoing monitoring to identify and report suspicious transactions and update customer information 

Customer due diligence seeks to detect money laundering strategies including layering and structuring, also known as “smurfing”—the breaking up of large money laundering transactions into smaller ones to evade reporting limits and avoid scrutiny.

One rule in place to foil layering is the AML holding period, which requires deposits to remain in an account for a minimum of five trading days before they can be transferred elsewhere.

Financial institutions are required to develop and implement a written AML compliance policy, which much be approved in writing by a member of senior management and overseen by a designated AML compliance officer. These programs must specify “risk-based procedures for conducting ongoing customer due diligence” and conduct “ongoing monitoring to identify and report suspicious transactions.”

History of Anti Money Laundering

Efforts to police illicit gains have a history stretching back centuries, while the term “money laundering” is only about 100 years old and in wide use for less than 50.

The first major piece of U.S. AML legislation was the 1970 Bank Secrecy Act, passed in part to thwart organized crime. In addition to requiring banks to report cash deposits of more than $10,000, the legislation also required banks to identify individuals conducting transactions and to maintain records of transactions. The U.S. Supreme Court upheld the Bank Secrecy Act’s constitutionality in 1974, the same year “money laundering” entered wide use amid the Watergate scandal.

Additional legislation passed in the 1980s amid increased efforts to fight drug trafficking, in the 1990s to expand financial monitoring and in the 2000s to cut off funding for terrorist organizations.

Anti-money laundering assumed greater global prominence in 1989, when a group of countries and international organizations formed the Financial Action Task Force (FATF). Its mission is to devise international standards to prevent money laundering and promote their adoption. In October 2001, following the 9/11 terrorist attacks, FATF expanded its mandate to include combating terrorist financing.

Another important organization in the fight against money laundering is the International Monetary Fund (IMF). Like the FATF, the IMF has pressed its member countries to comply with international standards to thwart terrorist financing.

The United Nations included AML provisions in its 1998 Vienna Convention addressing drug trafficking, the 2001 Palermo Convention against international organized crime and the 2005 Merida Convention against corruption.

The Anti-Money Laundering Act of 2020, passed in early 2021, was the most sweeping overhaul of U.S. AML regulations since the Patriot Act of 2001. The 2021 legislation included the Corporate Transparency Act, which made it harder to use shell companies to evade anti-money laundering and economic sanctions measures.

The legislation also subjected cryptocurrency exchanges as well as arts and antiquities dealers to the same customer due diligence requirements as financial institutions.