How to Legally Transfer After-Tax Money into a Tax-Free Roth IRA - Rodgers & Associates
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How to Legally Transfer After-Tax Money into a Tax-Free Roth IRA

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 (MAGIMarried Filing Separately (MAGI)Maximum Contri­bution for Individuals under age 50Maximum Contri­bution for Individuals age 50 and older
under $124,000under $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
Source: Schwab​.com

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.