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

Retirement Planning

The IRS has just handed us another tool to use for building Roth IRAs. A recent IRS 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 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 (a total of $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 have to 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 was never clear on whether the pro-rata rule would apply to distri­b­u­tions from an employer-sponsored plan. 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 money and have the employer plan send a check for the after-tax portion to the partic­ipant. The fact that this can now be deposited directly to a Roth was finally made clear in the latest ruling.

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 money is to 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 adjusted gross income (AGI) below $181,000 and singles with AGIs below $114,000 can contribute up to $5,500 to a Roth IRA…$6,500 if they are age 50 and older in 2014. The amount of contri­bu­tions are phased out until no contri­bu­tions are permitted when AGI tops $191,000 (joint filers) or $129,000 (single filers).

Taxpayers with AGI above these levels cannot contribute to a Roth unless they make non-deductible 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 and separating these contri­bu­tions to a Roth when they rollover the account. Making after-tax contri­bu­tions for a number of years before retirement could build a sizeable Roth IRA providing a source of tax-free income.

In order to implement this strategy, your employer may have to amend the plan to accept after-tax contri­bu­tions if they are not allowed currently. There is a $52,000 ceiling ($57,500 if 50 or older) on the amount of total contri­bu­tions that can be 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 ($17,500 or $23,000 if age 50 or older in 2014).

Let’s say a taxpayer over age 50 contributes the $23,000 maximum 401(k) contri­bution and their employer adds in $5,000. In this example, this person could make up to $29,500 of after-tax additions to their plan. Anyone consid­ering this strategy should check with their plan admin­is­trator to make sure top-heavy testing doesn’t place further restric­tions on the amount a highly compen­sated employee can contribute to the plan.

Unfor­tu­nately, the new 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 Tips:

  • 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 now be separated from pre-tax money and rolled directly into a Roth IRA.
  • High-income taxpayers can now build up a Roth IRA for their retirement by making after-tax contri­bu­tions to their company plan and roll them into a Roth when they separate from service.