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American Opportunity Tax Credit (AOTC): Definition and Benefits

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American Opportunity Tax Credit (AOTC): Definition and Benefits

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What Is the American Opportunity Tax Credit (AOTC)?

The American Opportunity Tax Credit (AOTC) is a tax credit for qualified education expenses associated with the first four years of a student’s postsecondary education. The maximum annual credit is $2,500 per eligible student. The student, someone claiming the student as a dependent, or a spouse making postsecondary education payments can claim the AOTC on their tax return.

Key Takeaways

  • The American Opportunity Tax Credit (AOTC) helps offset the costs of postsecondary education for students or their parents (if the student is a dependent).
  • The AOTC allows an annual $2,500 tax credit for qualified tuition expenses, school fees, and course materials.
  • Room and board, medical costs, transportation, and insurance do not qualify, nor do qualified expenses paid for with 529 plan funds.
  • To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 if married filing jointly).

Understanding the American Opportunity Tax Credit (AOTC)

With the AOTC, a household with a qualifying student can receive a maximum $2,500 tax credit per year for the first four years of higher education. Parents claiming a dependent child who is a full-time student ages 19 to 24 can claim an additional $500 Child Tax Credit.

The AOTC helps with educational costs such as tuition and other expenses related to a student’s coursework. Eligible students (or their parents) can claim 100% of the first $2,000 spent on school expenses and 25% of the next $2,000. This comes out to a maximum credit of $2,500: (100% × $2,000) + (25% × $2,000).

The American Opportunity Tax Credit is partially refundable, which means that it could provide a refund even if your tax liability is $0.

In general, tax credits are refundable, nonrefundable, or partially refundable. Up to $1,000 (40%) of the AOTC is refundable, making it a partially refundable tax credit. So, if the credit brings your tax liability to $0, you can receive 40% of your eligible credit (up to $1,000) as a refund.

AOTC Eligibility Requirements

Like other tax credits, you must meet specific eligibility requirements to claim the AOTC.

Who Can Claim the AOTC?

To claim the AOTC on your tax return, you must meet all three of these requirements:

  • You pay qualified education expenses for higher education.
  • You pay the education expenses for an eligible student.
  • The eligible student is either you, your spouse, or a dependent whom you claim on your tax return.

Additionally, you must receive Internal Revenue Service (IRS) Form 1098-T to claim the credit. Here’s an example of a completed form:

Source: Internal Revenue Service

Which Students Qualify for the AOTC?

A student is eligible for the AOTC only if they meet certain requirements. Specifically, the student must:

  • Be taking courses toward a degree or some other recognized education qualification
  • Be enrolled at least part time for at least one academic period beginning in the tax year
  • Not have finished the first four years of higher education at the beginning of the tax year
  • Not have claimed the AOTC (or the former Hope credit) for more than four tax years
  • Not have a felony drug conviction at the end of the tax year

Academic periods can be quarters, trimesters, semesters, or summer school sessions. If the school doesn’t have academic terms, you can treat the payment period as an academic period.

Which Expenses Qualify for the AOTC?

For the purposes of the AOTC, qualified education expenses include tuition and some related costs required for attending an eligible educational institution. An eligible educational institution is any accredited public, nonprofit, or private college, university, vocational school, or other postsecondary educational institution. Related expenses include:

  • Student activity fees paid to the school as a condition of enrollment or attendance
  • Books, supplies, and equipment needed for classes, whether or not you buy them from the school

Insurance, medical expenses (including student health fees), room and board, transportation, and living expenses do not count as qualified education expenses.

You can pay for qualified education expenses with student loans. However, you can’t claim the credit if you paid for expenses with scholarships, grants, employer-provided assistance, or funds from a 529 savings plan.

What Are the Income Limits for the AOTC?

To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 if married filing jointly). The credit begins to phase out above these limits and disappears entirely if your MAGI is above $90,000 ($180,000 for married filing jointly).

Income Limits for the American Opportunity Tax Credit
  Single Married Filing Jointly
Full Credit $80,000 or less $160,000 or less
Partial Credit More than $80,000 but less than $90,000 More than $160,000 but less than $180,000
No Credit More than $90,000 More than $180,000
Source: Internal Revenue Service

AOTC vs. Lifetime Learning Credit

The AOTC and the Lifetime Learning Credit (LLC) are popular tax breaks that people with educational expenses can claim on their annual tax returns. While similar, the LLC and the AOTC differ in several ways.

With the LLC, you can claim up to 20% of the first $10,000 of qualifying expenses ($2,000). The LLC is not limited to students pursuing a degree or studying at least part time. Instead, it covers a broader group of students—including part-time, full-time, undergraduate, graduate, and courses for skill development. Finally, the LLC is nonrefundable, meaning that once your tax bill hits zero, you won’t receive a refund on any credit balance.

American Opportunity Tax Credit (AOTC) vs. Lifetime Learning Credit (LLC)
 Criteria AOTC LLC
Maximum Benefit Up to $2,500 per student Up to $2,000 per return
Credit Type Partially refundable (40% of credit) Nonrefundable
MAGI Limit (Single) $90,000 $80,000
MAGI Limit (Married Filing Jointly) $180,000 $160,000
# of Tax Years Available Four per student Unlimited
Program Requirement Degree seeking N/A
Course Load At least half time for at least one academic period At least one course
Qualified Expenses Tuition, required fees, and course materials Tuition and fees
Felony Drug Conviction Not allowed N/A
Source: Internal Revenue Service

If you’re eligible for both the AOTC and the LLC, be sure to assess your individual situation to determine which tax credit provides the greater benefit. The partial refundability of the AOTC can be an important factor. Of course, some taxpayers may only qualify for the LLC, making the decision easy.

You can claim the AOTC and the LLC (as well as the deduction for tuition and fees) on the same tax return—but not for the same student or the same qualified expenses.

Other Tax Breaks for Education

Federal and state governments support higher education expenses through various tax credits, tax deductions, and tax-advantaged savings plans. Each of these programs can help lower your income tax liability and make education more affordable. Beyond the AOTC and the LLC, be sure to claim any education-related tax deductions for which you may be eligible, including those for:

Savings plans can also help with higher education expenses. These are tax-advantaged accounts that allow you to save—and pay for—education expenses. Two popular programs include:

Thanks to the Tax Cuts and Jobs Act, you can now use up to $10,000 of 529 plan distributions to pay for K–12 costs per beneficiary each year. Previously, you could use the funds only for college and other postsecondary education expenses.

AOTC Example

Rosa is a full-time undergraduate college student at a four-year institution. She also works for a law firm. Her parents have a substantial 529 savings account in place, but it doesn’t cover all of Rosa’s expenses. Rosa also has a student loan with deferred payments and interest until after graduation.

Rosa and her family pay her tuition with student loans and use funds from a 529 plan to cover room and board. Rosa receives her annual 1098-T statement and, since she is working, she plans to take the AOTC herself. She is eligible for both the AOTC and the LLC, but she chooses the AOTC because it provides a larger credit and is partially refundable.

Rosa paid her tuition with a student loan, which is allowable for the AOTC. The AOTC helps alleviate any tax that she owes and she also gets a partial refund. Rosa doesn’t owe anything on her loans until after she graduates. The money distributed from the 529 was tax-free because it was used for room and board, which is a qualified 529 expense.

How Do I Claim the American Opportunity Tax Credit (AOTC)?

To claim the American Opportunity Tax Credit (AOTC), complete Form 8863 and submit it with your Form 1040 or 1040-SR when filing your annual income tax return. Enter the nonrefundable part of the credit on Schedule 3 of your 1040 or 1040-SR, line 3. The refundable portion of the credit goes on line 29 of the 1040 or 1040-SR.

Can I Claim the AOTC and the Lifetime Learning Credit?

Yes. You can claim the AOTC and the Lifetime Learning Credit (LLC) on the same tax return. However, you can’t claim both credits for the same student or the same expenses during a single tax year.

Can I Claim the AOTC if I Get a Grant?

Yes. However, you need to subtract that amount from your qualified education expenses before claiming the tax credit. So, if you have $5,000 in costs and a $4,000 grant, you would be able to claim $1,000 of qualified education expenses for the AOTC. For the purposes of the AOTC, grants include:

  • Tax-free parts of scholarships and fellowships
  • Pell Grants and other need-based education grants
  • Employer-provided assistance
  • Veterans’ educational assistance
  • Any other tax-free payments that you receive for educational aid (excluding gifts and inheritances)

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What Is the Accounting Equation, and How Do You Calculate It?

Written by admin. Posted in A, Financial Terms Dictionary

What Is the Accounting Equation, and How Do You Calculate It?

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What Is the Accounting Equation?

The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity.

This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side.

The accounting equation is also called the basic accounting equation or the balance sheet equation.

Key Takeaways

  • The accounting equation is considered to be the foundation of the double-entry accounting system.
  • The accounting equation shows on a company’s balance that a company’s total assets are equal to the sum of the company’s liabilities and shareholders’ equity.
  • Assets represent the valuable resources controlled by the company. The liabilities represent their obligations.
  • Both liabilities and shareholders’ equity represent how the assets of a company are financed.
  • Financing through debt shows as a liability, while financing through issuing equity shares appears in shareholders’ equity.

Understanding the Accounting Equation

The financial position of any business, large or small, is based on two key components of the balance sheet: assets and liabilities. Owners’ equity, or shareholders’ equity, is the third section of the balance sheet.

The accounting equation is a representation of how these three important components are associated with each other.

Assets represent the valuable resources controlled by the company, while liabilities represent its obligations. Both liabilities and shareholders’ equity represent how the assets of a company are financed. If it’s financed through debt, it’ll show as a liability, but if it’s financed through issuing equity shares to investors, it’ll show in shareholders’ equity.

The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. Below are examples of items listed on the balance sheet.

Assets

Assets include cash and cash equivalents or liquid assets, which may include Treasury bills and certificates of deposit.

Accounts receivables list the amounts of money owed to the company by its customers for the sale of its products. Inventory is also considered an asset.

The major and often largest value asset of most companies be that company’s machinery, buildings, and property. These are fixed assets that are usually held for many years.

Liabilities

Liabilities are debts that a company owes and costs that it needs to pay in order to keep the company running.

Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.

Costs include rent, taxes, utilities, salaries, wages, and dividends payable.

Shareholders’ Equity

The shareholders’ equity number is a company’s total assets minus its total liabilities. 

It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities. This would then be distributed to the shareholders.

Retained earnings are part of shareholders’ equity. This number is the sum of total earnings that were not paid to shareholders as dividends.

Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or “retained”) for future use.

Accounting Equation Formula and Calculation


Assets = ( Liabilities + Owner’s Equity ) \text{Assets}=(\text{Liabilities}+\text{Owner’s Equity})
Assets=(Liabilities+Owner’s Equity)

The balance sheet holds the elements that contribute to the accounting equation:

  1. Locate the company’s total assets on the balance sheet for the period.
  2. Total all liabilities, which should be a separate listing on the balance sheet.
  3. Locate total shareholder’s equity and add the number to total liabilities.
  4. Total assets will equal the sum of liabilities and total equity.

As an example, say the leading retailer XYZ Corporation reported the following on its balance sheet for its latest full fiscal year:

  • Total assets: $170 billion
  • Total liabilities: $120 billion
  • Total shareholders’ equity: $50 billion

If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive at ($50 billion + $120 billion) = $170 billion, which matches the value of the assets reported by the company.

About the Double-Entry System

The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. 

Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity.

For a company keeping accurate accounts, every business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability.

If a business buys raw materials and pays in cash, it will result in an increase in the company’s inventory (an asset) while reducing cash capital (another asset). Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting.

The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left side value of the equation will always match the right side value.

In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity.

The global adherence to the double-entry accounting system makes the account keeping and tallying processes more standardized and more fool-proof.

The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exists between each liability (or expense) and its corresponding source; or between each item of income (or asset) and its source.

Limits of the Accounting Equation

Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing. Investors must interpret the numbers and decide for themselves whether the company has too many or too few liabilities, not enough assets, or perhaps too many assets, or whether its financing is sufficient to ensure its long-term growth.

Real-World Example

Below is a portion of Exxon Mobil Corporation’s (XOM) balance sheet in millions as of Dec. 31, 2019:

  • Total assets were $362,597
  • Total liabilities were $163,659
  • Total equity was $198,938

The accounting equation is calculated as follows:

  • Accounting equation = $163,659 (total liabilities) + $198,938 (equity) equals $362,597, (which equals the total assets for the period)
Image by Sabrina Jiang © Investopedia 2020

Why Is the Accounting Equation Important?

The accounting equation captures the relationship between the three components of a balance sheet: assets, liabilities, and equity. All else being equal, a company’s equity will increase when its assets increase, and vice-versa. Adding liabilities will decrease equity while reducing liabilities—such as by paying off debt—will increase equity. These basic concepts are essential to modern accounting methods.

What Are the 3 Elements of the Accounting Equation?

The three elements of the accounting equation are assets, liabilities, and shareholders’ equity. The formula is straightforward: A company’s total assets are equal to its liabilities plus its shareholders’ equity. The double-entry bookkeeping system, which has been adopted globally, is designed to accurately reflect a company’s total assets.

What Is an Asset in the Accounting Equation?

An asset is anything with economic value that a company controls that can be used to benefit the business now or in the future. They include fixed assets such as machinery and buildings. They may include financial assets, such as investments in stocks and bonds. They also may be intangible assets like patents, trademarks, and goodwill.

What Is a Liability in the Accounting Equation?

A company’s liabilities include every debt it has incurred. These may include loans, accounts payable, mortgages, deferred revenues, bond issues, warranties, and accrued expenses.

What Is Shareholders’ Equity in the Accounting Equation?

Shareholders’ equity is the total value of the company expressed in dollars. Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts. The remainder is the shareholders’ equity, which would be returned to them.

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401(a) Plan: What It Is, Contribution Limits, Withdrawal Rules

Written by admin. Posted in #, Financial Terms Dictionary

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What Is a 401(a) Plan?

A 401(a) plan is an employer-sponsored money-purchase retirement plan that allows dollar or percentage-based contributions from the employer, the employee, or both. The sponsoring employer establishes eligibility and the vesting schedule. The employee can withdraw funds from a 401(a) plan through a rollover to a different qualified retirement plan, a lump-sum payment, or an annuity.

Key Takeaways

  • A 401(a) plan is employer-sponsored, and both the employer and employee can contribute.
  • 401(a) plans are usually used by government and non-profit organizations.
  • 401(a) plans give the employer a larger share of control over how the plan is invested.
  • An employee can withdraw funds from a 401(a) plan through a rollover to a different qualified retirement plan, a lump-sum payment, or an annuity.
  • Investments in 401(a) plans are low risk and typically include government bonds and funds focused on value-based stocks.

Understanding a 401(a) Plan

There are a variety of retirement plans that employers can offer their employees. Each comes with different stipulations, restrictions, and some are better suited for certain types of employers.

A 401(a) plan is a type of retirement plan made available to those working in government agencies, educational institutions, and non-profit organizations. Eligible employees who participate in the plan include government employees, teachers, administrators, and support staff. A 401(a) plan’s features are similar to a 401(k) plan, which are more common in profit-based industries. 401(a) plans do not allow employees to contribute to 401(k) plans, however.

If an individual leaves an employer, they do have the option of transferring the funds in their 401(a) to a 401(k) plan or individual retirement account (IRA).

Employers can form multiple 401(a) plans, each with distinct eligibility criteria, contribution amounts, and vesting schedules. Employers use these plans to create incentive programs for employee retention. The employer controls the plan and determines the contribution limits.

To participate in a 401(a) plan, an individual must be 21 years of age and have been working in the job for a minimum of two years. These conditions are subject to vary.

Contributions for a 401(a) Plan

A 401(a) plan can have mandatory or voluntary contributions, and the employer decides if contributions are made on an after-tax or pre-tax basis. An employer contributes funds to the plan on an employee’s behalf. Employer contribution options include the employer paying a set amount into an employee’s plan, matching a fixed percentage of employee contributions, or matching employee contributions within a specific dollar range.

The majority of voluntary contributions to a 401(a) plan are capped at 25% of an employee’s annual pay.

Investments for a 401(a) Plan

The plan gives employers more control over their employees’ investment choices. Government employers with 401(a) plans often limit investment options to only the safest and most secure options to minimize risk. A 401(a) plan assures a certain level of retirement savings but requires due diligence by the employee to meet retirement goals.

Vesting and Withdrawals for a 401(a) Plan

Any 401(a) contributions an employee makes and any earnings on those contributions are immediately fully vested. Becoming fully vested in the employer contributions depends on the vesting schedule the employer sets up. Some employers, especially those who offer 401(k) plans, link vesting to years of service as an incentive for employees to stay with the company.

The Internal Revenue Service (IRS) subjects 401(a) withdrawals to income tax withholdings and a 10% early withdrawal penalty unless the employee is 59½, dies, is disabled, or rolls over the funds into a qualified IRA or retirement plan through a direct trustee-to-trustee transfer. 

Qualifying for Tax Credits

Employees who contribute to a 401(a) plan may qualify for a tax credit. Employees can have both a 401(a) plan and an IRA at the same time. However, if an employee has a 401(a) plan, the tax benefits for traditional IRA contributions may be phased out depending on the employee’s adjusted gross income.

401(a) vs. 401(k) Plans

A 401(a) plan is similar to a 401(k), another type of employer-sponsored plan that provides a tax advantage for retirement investments. The main difference is who participates: while 401(k) plans are intended for private sector employees, 401(a) plans are directed towards employees of government bodies, educational institutions, and charitable organizations. These plans also tend to offer fewer, more conservative investment options than those found in a 401(k) plan.

If you work in the private sector, you can contribute to a 401(k) plan after one year. But if your employer offers a 401(a) plan, it takes two years.

There are also important rule differences between the two types of plans. With a 401(k) plan, participation is voluntary, and the employee can decide how much money to contribute towards the plan so long as it is below the legal limit. Employers may match a portion of the employee’s contribution, but many do not.

But in a 401(a) plan, employers can make it mandatory for their employees to participate. But employers are also required to contribute to their employees’ accounts. They can also decide whether the 401(a) plan is to be funded with pre-tax or after-tax dollars.

401(a) vs. 401(k) plans

401(k)

  • Offered by private sector employers

  • Employees become eligible after one year.

  • Employees elect to participate in the plan.

  • Employers may match a portion of employee contributions.

  • More investment options.

401(a)

  • Offered by government bodies, educational institutions, and charities.

  • Employees become eligible after two years.

  • Employers can make participation mandatory.

  • Employers must contribute to their employee’s plans.

  • Investment options tend to be fewer and more conservative than a 401(k)

Tips for a 401(a) Plan

As with other types of retirement plans, it is important to understand the rules and fees associated with a 401(a) before making a significant contribution. This caution can help reduce your costs and expenses further down the line.

Here are some ways to make the most out of a 401(a) or any other tax-advantaged retirement account:

  • Understand the Rules. As with other tax-advantaged retirement accounts, there are strict rules about what you can do with the money in a 401(a) account. If you take money out before you reach age 59½, you may face a 10% penalty, except for certain emergency expenses. It is important to understand the rules for holding and closing your account to avoid unexpected tax implications.
  • Understand the fees. In addition to taxes, there are also fees associated with a 401(a) account that are used to offset the administrative costs of maintaining your investment account. High plan fees can easily eat into your portfolio gains, so it is important to talk to your employer and understand how much the plan will actually cost you.

What Happens to My 401(a) Plan When I Quit?

The money in your 401(a) or other employer-sponsored retirement account belongs to you, even after you leave the employer. When you lose your job, that money can be taken as a distribution (with a possible early withdrawal penalty) or rolled into a different retirement account, such as an IRA.

What’s the Difference Between a 401(a) and 403(b)?

A 401(a) plan and a 403(b) are both types of tax-advantaged retirement plans available to certain public-sector employees. Unlike a 401(a), a 403(b) plan is aimed at employees of public schools and tax-exempt organizations, and their investment options are limited to annuities or mutual funds. The main difference is that an employer can make participation in a 401(a) plan mandatory, while it remains voluntary for employees to participate in a 403(b).

How Much Can I Invest in a 401(a) Plan?

A 401(a) plan does not have the same investment limits as a 401(k) plan. Most plans cap voluntary contributions to 25% of the employee’s take-home pay.

The Bottom Line

A 401(a) plan is a type of tax-advantaged account that allows public-sector employees to save for retirement. These plans typically offer fewer investment options than other types of plans, and they are also relatively low-risk. Although employers can make participation mandatory, there are may also be a tax credit for those who contribute to a 401(a).

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After-Tax Contribution: Definition, Rules, and Limits

Written by admin. Posted in A, Financial Terms Dictionary

Account Balance Defined and Compared to Available Credit

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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.

Key Takeaways

  • After-tax contributions can be made to a Roth account.
  • Typically funding a 401(k) is done with pre-tax dollars out of your paycheck.
  • If you think you will have a higher income after retirement, contributing to a Roth may make sense.
  • The 2022 annual limit on funding an IRA is $6,000 per year if under 50 years of age ($6,500 for 2023).
  • There is an income threshold for being eligible to contribute to a Roth IRA account.

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.

If you have a pre-tax or traditional account, you will have to pay taxes on money withdrawn before age 59½, and the funds are subject to a hefty early withdrawal penalty.

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.

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