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.
- 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.