A 2014 IRS ruling makes it easier for taxpayers to move after-tax 401(k) contributions directly to a Roth IRA. Prior to the notice, it was possible to achieve a tax-free Roth conversion of after-tax dollars in an employer plan, but it was a complicated process using 60-day (indirect) rollovers rather than trustee-to-trustee transfers.
Not only did this involve several steps but it required taxpayers to have sufficient funds outside the plan to make up the 20% mandatory withholding that applied to the taxable portion of the distribution. Plus, when a 60-day rollover is not executed correctly, it could be deemed a taxable distribution, which is also subject to a 10% early-withdrawal penalty for participants under age 59½.
The prospect of a hassle-free Roth conversion may inspire some people to contribute additional after-tax money to their employer plans. Unlike the case with a Roth IRA, there are no income restrictions for contributions to a 401(k), so higher-income individuals may jump at this chance to build a tax-free income source for their retirement. Participants who already have a mix of pre-tax and after-tax funds in their 401(k)s could also benefit from the new rules.
A Larger Shelter
The ability to make after-tax contributions to a 401(k) plan is not available to everyone; it depends on the individual plan. Generally, plan participants must maximize salary deferrals to traditional and/or Roth 401(k) accounts before they can add after-tax money to the mix.
The annual employee contribution limit to a 401(k) plan in 2015 is $18,000, or $24,000 for those 50 and older. Yet the law actually allows an “overall limit” of $53,000 or 100% of compensation, whichever is less, to be put into a 401(k) on a worker’s behalf. This overall amount includes employer matches and employee after-tax contributions, if allowed.
Highly compensated workers (salary above $120,000 in 2015) are subject to additional rules based on the employer plan’s overall participation rate.
The Roth Advantage
Pre-tax contributions to a traditional 401(k) reduce a worker’s current tax bill, but withdrawals are taxed as ordinary income. A Roth 401(k) is funded with after-tax money just like a Roth IRA, and qualified withdrawals are tax-free after age 59½ as long as the five-year holding requirement has been met (under current law). By contrast, only the earnings on after-tax contributions to a traditional IRA are taxable when they are withdrawn.
You must take required minimum distributions (RMDs) from most tax-deferred retirement plans starting at age 70½. But a Roth IRA allows you to avoid RMDs during your lifetime. The money continues to accumulate tax-free until you need it, or you can leave this income-tax-free asset to your heirs.
Ready to Roll
When you leave your employer, any after-tax 401(k) contributions can be transferred directly to a Roth IRA at the same time that pre-tax contributions are directed to a traditional IRA.
For example, let’s say your 401(k) account balance is $100,000: $80,000 of pre-tax dollars and $20,000 of after-tax dollars. You can request a single $100,000 distribution, with instructions for the trustee-to-trustee transfer of $80,000 to a traditional IRA and $20,000 to a Roth IRA.
Some plans may accommodate only one direct transfer per distribution. In this case, if you wish to separate pre-tax and after-tax money, you should directly transfer pre-tax funds to a traditional IRA and request a 60-day rollover of after-tax funds to a Roth IRA.
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2015 Emerald Connect, LLC.