What You Need to Know
You may want to pay close attention to the tax-friendly rules regarding after-tax money in your 401(k) plan or similar plan. You stand to benefit if you have made after-tax contributions, other than Roth contributions, to your retirement plan at work.
Then and Now
A couple years ago, a rule was introduced, titled IRS Notice 2014-54, which changed the game for rollovers from employer plans when the payout includes both pre-tax and after-tax dollars. The standard rule for contributing to a 401(k) plan is that contributions are made using pre-tax dollars and taxable as ordinary income when withdrawn. Some plans also allow non-deductible after-tax contributions to be made in excess of the pre-tax contributions made. For those who have maxed out on pre-tax contributions, but wish to increase their retirement savings, it has been appealing to make additional after-tax contributions; However, dealing with the IRS when you were ready to take distributions from these plans was akin to walking through a minefield of tax issues.
The ever-present and burning question for employee plan participants has always been: if I have after-tax money (in a 401(k), 403(b), 457, etc.), can I convert that to a Roth IRA tax-free?
Generally the answer was “no”. Whenever an employer plan is directly converted to a Roth IRA, after-tax contributions were applied on a pro rata basis to the distribution. Requesting that only the after-tax contributions be converted tax-free to a Roth IRA was not possible.
Nevertheless, creative tax attorneys and clever accountants tried and found themselves wrestling with the IRS on this issue for years.
With the issuance of the IRS Notice 2014-54 the rules have become more favorable. Since its passing, taxpayers have the ability to allocate after-tax contributions directly to a Roth IRA. The even better news is the conversion of after-tax contributions to a Roth IRA does not create any tax liability since the taxes were previously paid on the amounts contributed.
A Closer Look How It May Benefit You
You may want to roll over any employer plan after-tax contributions to Roth IRAs
Many workers choose to make pretax contributions to their employer plan to obtain an immediate tax deduction. During the pre-Roth era in the 1980s and 1990s, it was common to make after-tax contributions to an employer’s retirement plan, especially for highly compensated workers.
Now is the time to review account statements from all your previous employer plans and determine if you made any after-tax contributions. Since employers are required to keep track of pre-tax and after-tax contributions those amounts should be easily identified on your statements. You can contact your plan administrator to determine the exact amounts of each.
Once any after-tax contributions are identified, you can begin consolidating these accounts and allocate the after-tax contributions (excluding earnings) to a Roth IRA so the earnings can potentially grow and be distributed tax-free (subject to normal Roth distribution requirements).
Or, you may want to roll over your current employer plan after-tax contributions to Roth IRAs
While you generally have no restriction on rolling over your prior employer plans to IRAs, the ability to do so with your current employer is based upon your age and the requirements of plan.
Many employers allow for “in-service distributions” that permit employees to roll over their account balance; typically this is available only once the employee has attained an age specified in the employer’s plan (55, 59 1/2). With this new rule, taking an in-service distribution sooner than later may be beneficial. If you convert the after-tax contributions to a Roth IRA, you can begin the journey of tax-free growth and distribution.
Consider making after-tax contributions to fund future Roth IRAs
Getting money into Roth accounts can be difficult. Income limits may prevent direct Roth IRA contributions; your employer may not provide a Roth plan (Roth 401(k) Roth 403(b)); and having a traditional IRA account may prevent funding “backdoor” Roth conversions. Usually, the only solution left is to convert existing qualified plans or Traditional IRAs to Roth IRAs.
This new IRS ruling creates a new method for individuals to fund Roth accounts. Instead of making pre-tax contributions to their employer plan, an individual could intentionally elect to make only after-tax contributions, if allowed by your employer. These after-tax contributions will then be available upon separation from service or retirement allowing you to roll over to a Roth IRA without additional taxes or penalties.
In 2016, employee contributions to their 401(k), 403(b), or 457(b) were limited to $18,000 plus an additional $6,000 catch-up, if over age 50. Depending on the structure of the plan, employees may be able to make after-tax contributions in excess of these limits. Ultimately, the total of all employee contributions (pre-tax, Roth, and after-tax) plus employer contributions (match, profit-sharing, etc.) cannot exceed $53,000 or $59,000 if over age 50.
Keep in mind a few rules surrounding this change. Allocating after-tax contributions to a Roth IRA is possible only when the entire account (including both pretax and after-tax amounts) is rolled over. If only part is rolled over, the pro rata rules still apply. The IRS notice is also only applicable to after-tax contributions to employer plans; it doesn’t apply to IRAs.
While this IRS ruling is very welcomed news, you should still thoroughly review your specific tax issues with a qualified tax adviser and financial planner. This information is not intended to be a substitute for specific individualized tax advice.
The new rules are spelled out in the following IRS ruling [PDF] Notice 2014-54 – IRS.gov
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