If you’re thinking about rolling over after-tax money from your 401(k) into a Roth IRA, the way you do it has definite tax implications. Read the following carefully and discuss it with a financial advisor to be sure you do this in the most tax-favorable way for you. Doing it wrong could cost you.
In September, 2014, the IRS issued some much anticipated and, some say, much needed, guidance on the allocation of after-tax assets to retirement plan rollovers. The rule directly impacts retirement plan participants with after-tax cash in a 401k plan.
The move by Uncle Sam attempts to answer a common question between retirement plan participants and their financial advisors: “If I have after-tax assets in a 401(k), when I take a distribution from my plan, can I take the after-tax cash and convert it to a Roth IRA, with no tax consequence?”
Greater Guidance and Clarity
With IRS Guidance Notice #2014-54, the IRS provides some clarity on the issue, ultimately answering “yes” to that question.
Effectively, the rule allows 401(k) plan participants to bypass current taxes on retirement plan distributions that include after-tax amounts. In plain English, the move enables 401(k) investors with after-tax money in their account to roll it into a Roth IRA where it can grow tax-free, as opposed to tax-deferred. Retirement plan participants won’t have to pro rate taxes on the distribution.
The move affects a significant number of 401(k) plan participants. Data from Aon Hewitt show that 6.6 percent of 401(k) participants make after-tax contributions, when possible.
As usual, the IRS adds some qualifiers to the new rule that retirement savers need to know about. Specifically…
- The ruling only applies to distributions with after-tax assets.
- The ruling applies to disbursements not just from 401(k) plans, but also from 403(b) or 457 plans.
- The ruling has no effect on the pre-tax dollars placed in a traditional employer 401(k).
- The ruling took place immediately, although language from #2014-54 implied the new statute took effect January 1, 2015. But there is a caveat from the IRS: “The applicability date of the regulations is proposed to be Jan. 1, 2015. However, in accordance with § 7805(b)(7), taxpayers are permitted to apply the proposed regulations to distributions made before the applicability date, so long as such earlier distributions are made on or after Sept. 18, 2014.” Any 401(k) plan holder who had already made this move would be left alone by the IRS, under a “reasonable interpretation” statute cited in the ruling.
- Prior to the new rule, participants had to allocate pro rated portions of pretax and after-tax contributions to each direct rollover.
Example of How the Rule Can Help 401(k) Plan Participants
In the IRS ruling, the agency offered an example, under section V , example 4, of the statute:
The plan participant’s 401(k) balance holds $200,000 of pretax amounts and $50,000 of after-tax amounts. In his job, the plan participant “separates from service,” meaning he either leaves the job voluntarily or is fired, and seeks a distribution of $100,000. The pretax amount of the distribution is $80,000 (four-fifths) and the after-tax amount of the distribution is $20,000 (one-fifth). Here’s how it plays out, according to the IRS: “The employee is permitted to allocate the $80,000 that consists entirely of pretax amounts to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after-tax amounts.”
A ‘Win-Win’ for Retirement Savers
Depending on your age and the rules of your employer’s plan, you may still face restrictions on how much pre- and/or post-tax money you can put into your specific employer-sponsored plann.
But past that, Rule 2014-54 appears to be a solid (and relatively rare) “win-win” for 401(k) investors looking to roll after-tax dollars into a Roth IRA. Ask your financial professional to help you take full advantage.