Prior to the IRS’ ruling last fall, it was unclear whether you could convert after-tax 401k contributions to Roth. And if you did convert them, there was disagreement in the financial planning community on the process you needed to follow to comply with IRS policies. The IRS has now clarified how this conversion can be correctly accomplished.
IRS Notice 2014-54
Based on Notice 2014-54 (and related proposed regulations), employer-plan distributions can be split into more than one retirement vehicle with, for example, pre-tax money transferred directly to a traditional IRA (with no current tax liability) and after-tax money moved directly to a Roth IRA (with no conversion tax). Even though the new rules didn’t go into effect until January 1, 2015, taxpayers could apply this guidance to distributions made on or after September 18, 2014. (The guidance also applies to 403(b) and 457(b) plans.)
The Notice provides the following technical rules:
- When calculating the taxable portion of a distribution from a 401(k) plan, all distributions you receive at the same time are treated as a single distribution, even if the proceeds are going to multiple destinations. This is important for allocating pre-tax and after-tax contributions to a distribution. For example, assume your 401(k) account is $100,000, consisting of $60,000 (6/10s) of pre-tax dollars and $40,000 (4/10s) of after-tax dollars. You request that $20,000 be rolled directly over to an IRA and $20,000 paid to you. This is treated as a single $40,000 distribution from the 401(k) plan. Of this $40,000, $24,000 (6/10s) is pre-tax dollars, and $16,000 (4/10s) is after-tax dollars.
- If you receive a distribution (as defined above), and roll all or part of the distribution over to one or more eligible retirement plans, your pre-tax dollars will be deemed allocated first to any direct rollovers you make, and then to any 60-day (indirect) rollovers you make. After all your pre-tax dollars have been so allocated, any remaining amounts rolled over will consist of after-tax dollars.
- If you are making direct rollovers to more than one eligible retirement plan (or indirect rollovers to more than one plan), you can direct the trustee how to allocate the pre-tax dollars among those retirement plans prior to the time the direct rollovers are made.
The Notice includes the following examples:
Julie participates in a 401(k) plan. Her $250,000 account balance consists of $200,000 of pre-tax dollars and $50,000 of after-tax dollars. Julie leaves her job, and requests a distribution of $100,000. The $100,000 distribution is deemed to include $80,000 of pre-tax dollars ($100,000 x $200,000/$250,000), and $20,000 of after-tax dollars ($100,000 x $50,000/$250,000). Julie requests that $70,000 be directly rolled over to the 401(k) plan maintained by her new employer and that $30,000 be paid to her in cash. Because the pre-tax amount of the distribution ($80,000) exceeds the amount directly rolled over ($70,000), the amount directly rolled over to the new plan consists entirely of pre-tax dollars. The remaining amount paid to Julie (prior to any withholding tax) consists of $10,000 in pre-tax dollars and $20,000 in after-tax dollars. Prior to the 60th day after the distribution, Julie chooses to roll over $12,000 to an IRA. Because the amount rolled over in the 60-day rollover ($12,000) exceeds the remaining pre-tax dollars ($10,000), the amount rolled over to the IRA consists of $10,000 of pre-tax dollars and $2,000 of after-tax dollars.
The facts are the same as in Example 1, except that Julie chooses to make $82,000 of direct rollovers — $50,000 to the new 401(k) plan and $32,000 to an IRA. The remaining $18,000 is paid to Julie. Because the amount rolled over ($82,000) exceeds the pre-tax amount of the distribution ($80,000), the direct rollovers consist of $80,000 in pretax amounts and $2,000 in after-tax amounts. Julie is allowed to allocate the pre-tax dollars between the new 401(k) plan and the IRA prior to the time the direct rollovers are made.
The facts are the same as in Example 1, except that Julie chooses to make a direct rollover of $80,000 to a traditional IRA and $20,000 to a Roth IRA. Julie is permitted to allocate the $80,000 that consists entirely of pre-tax dollars to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after-tax dollars.
Why does this matter?
Prior to this ruling, we generally did not recommend making after-tax contributions to a 401k. Even though the original contribution wasn’t taxed again at distribution, all the earnings were taxed as regular income. The regular income tax treatment made it unattractive compared to the alternative of putting the money into a taxable investment account and having your capital gains and qualified dividends taxed at the lower capital gain rates.
With this change, you should still make your full contribution as regular (pre-tax) or Roth contributions up to the federal maximums ($18,000 for 2015 plus a $6,000 catch-up if you’re 50 or older before 12/31/2015). But if your employer allows you to make additional after-tax contributions, the opportunity to roll those into a Roth when you leave the company creates an appealing opportunity to get more money into the Roth bucket. Depending on your situation and other opportunities available to you, it may be a really good option to consider after you’ve maxed out other sources of tax-advantaged savings.
IRS Notice 2014-54 is titled Guidance on Allocation of After-Tax Amounts to Rollovers, and can be found at www.irs.gov/pub/irs-drop/n-14-54.pdf. Portions of this article adapted with permission of Broadridge Forefield Investor Communications Inc.