IRS Notice 2014–54 handed us another tool for building assets in a Roth IRA. The ruling provides a path for rolling over any after-tax money in an employer-sponsored plan, such as 401(k)s and 403(b)s, to a Roth IRA. Employees with after-tax money in these plans can take a complete distribution and direct the plan administrator to send pre-tax dollars to a traditional IRA or another plan and then roll the after-tax contributions into a Roth IRA tax-free.
Rolling after-tax money in an employer plan to a Roth has been an area of uncertainty among tax professionals and financial planners because of the pro-rata rule. This rule applies to non-deductible contributions in a traditional IRA. Distributions from an IRA that contains both pre-tax dollars (deductible contributions and earnings) and after-tax dollars (non-deductible contributions) must be allocated “pro-rata” to determine the taxable amount of the distribution.
The formula for the pro-rata calculation is – the total after-tax money in all IRAs divided by the total value of all IRAs multiplied by the amount converted. For example, a taxpayer made three $5,000 non-deductible contributions to an IRA over the past couple of years ($15,000). That IRA is now worth $20,000, including growth. The taxpayer also has an IRA Rollover account that is worth $80,000. When she converts the $20,000 IRA to a Roth, $3,000 will be considered after-tax and $17,000 will be considered pre-tax ($15,000 divided by $100,000 = 15%; $20,000 x 15% = 3,000). Even though she only made after-tax contributions to the $20,000 IRA, the IRS says taxpayers must consider the value of all IRAs to determine the pro-rata portion that is after-tax. In this example, the IRA rollover now has $12,000 in after-tax money.
The IRS notice clarified the pro-rata rule does not apply to distributions from an employer-sponsored plan at the time of a rollover. Many financial advisers didn’t want to take the risk of separating after-tax money during a rollover and move it into a Roth. However, it is possible to separate after-tax cash and have the employer plan send a check for the after-tax portion to the participant.
There are only a few rules to follow to do the transaction properly. The transfer of after-tax and pre-tax money must be done at the same time. The taxpayer must instruct the plan administrator that the after-tax cash will be sent to a different account. That’s it.
High-income taxpayers now have a way to get money into a Roth IRA without choosing the Roth 401(k) option. Only married taxpayers with a combined Modified adjusted gross income (MAGI) below $196,000 and singles with MAGIs below $124,000 can contribute the maximum to a Roth IRA. Contributions are phased out until no contributions are permitted when MAGI tops $206,000 (joint filers) or $139,000 (single filers).
Roth IRA Contribution and Income Limits in 2020
| Single Filers (MAGI) | Married Filing Jointly (MAGI | Married Filing Separately (MAGI) | Maximum Contribution for Individuals under age 50 | Maximum Contribution for Individuals age 50 and older |
|---|---|---|---|---|
| under $124,000 | under $196,000 | $0 | $6,000 | $7,000 |
| $125,500 | $197,000 | $1,000 | $5,400 | $6,300 |
| $127,000 | $198,000 | $2,000 | $4,800 | $5,600 |
| $128,500 | $199,000 | $3,000 | $4,200 | $4,900 |
| $130,000 | $200,000 | $4,000 | $3,600 | $4,200 |
| $131,500 | $201,000 | $5,000 | $3,000 | $3,500 |
| $133,000 | $202,000 | $6,000 | $2,400 | $2,800 |
| $134,500 | $203,000 | $7,000 | $1,800 | $2,100 |
| $136,000 | $204,000 | $8,000 | $1,200 | $1,400 |
| $137,500 | $205,000 | $9,000 | $600 | $700 |
| $139,000 & over | $206,000 & over | $10,000 & over | $0 | $0 |
Taxpayers with MAGI above these levels cannot contribute to a Roth unless they make non-deductible IRA contributions and convert them to a Roth. This may not be feasible if they already have pre-tax money in IRA accounts because of the pro-rata rule. The other option could be contributing to a Roth 401(k). However, this option would take away from the amount they can contribute pre-tax, reducing current tax liability.
Now, upper-income taxpayers can build a Roth IRA by making after-tax contributions to their employer plan. After-tax contributions will be directed into a Roth when they roll over the account. Compounding after-tax contributions before retirement could build a sizeable Roth IRA. Roth IRAs provide a source of tax-free income
in retirement.
To implement this strategy, your employer may have to amend the plan to accept after-tax contributions if they are not allowed currently. In 2020, there is a $57,000 ceiling ($63,500 if 50 or older) on the total contributions made to a retirement plan on a worker’s behalf. Employer and employee contributions count toward the cap. Taxpayers will want to make the maximum pre-tax contributions first ($19,500 or $26,000 if age 50 or older in 2020).
Let’s say a taxpayer over age 50 contributes the $26,000 maximum 401(k) contribution, and their employer adds in $5,000. In this example, this person could make up to $31,000 of after-tax additions to their plan. Anyone considering this strategy should check with their plan administrator to ensure top-heavy testing doesn’t place further restrictions on the amount a highly compensated employee can contribute to the plan.
Unfortunately, the ruling doesn’t change the pro-rata rule for non-deductible contributions made to a traditional IRA. Taxpayers won’t be able to segregate just the non-deductible contributions and roll them tax-free into a Roth.
Rick’s Insights:
- The pro-rata rule prohibits allocating 100% of contributions to after-tax money in a traditional IRA.
- After-tax money in an employer-sponsored plan can be separated from pre-tax money and rolled directly into a Roth IRA.
- High-income taxpayers can build up a Roth IRA for their retirement by making after-tax contributions to their company plan and rolling them into a Roth when they separate from service.
