The Roundabout Way to a Roth IRA
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 By contrast, only the earnings on after-tax contributions to a traditional IRA are taxable when they are withdrawn.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.