New IRS Rule Can Make Big Difference in 401(k) Contributions

Separating pre-tax, after-tax contributions in rollovers lets people put more in Roth IRA - regardless of income.

People who’ve made both pre-tax and after-tax contributions to their workplace retirement plan can now easily separate them when rolling them over to traditional and Roth IRAs, thanks to a recent IRS ruling.

It can make a big difference for some. A big advantage is that after-tax contributions to a 401(k) or 403(b) plan now can be rolled over directly into a Roth IRA.

Pre-tax contributions can be rolled over into a traditional IRA, where they’ll grow tax-deferred.

Until recently, an employee whose retirement plan included both pre-tax and after-tax contributions faced a confusing situation when retiring or changing jobs. Each distribution had to include a prorated share of after-tax and pre-tax contributions.

When funds were sent to a Roth IRA, the account holder had to pay prorated taxes on the pre-tax portion of the transfer. When the funds were sent to a traditional IRA, investment earnings produced by after-tax dollars were simply tax-deferred. They would eventually be taxed at ordinary income rates, instead of at lower capital gains rates that would apply if the after-tax funds were not rolled over and simply invested in a taxable account.

Under its Sept. 18 notice, the IRS now lets you separate blocks of contributions when choosing where to send them, as long as the distributions are made at the same time. Therefore, when you roll over your 401(k) or other qualified retirement plan, you can avoid rolling any portion of your after-tax contributions into a traditional IRA, where any growth will be taxed at ordinary income rates when distributed.

Because you can now direct rollovers to different accounts for pre-tax and after-tax contributions, you can match the tax character of the contributions to the retirement account that treats them most favorably.

Let’s say Charles has $250,000 in his employer’s 401(k) plan, which does not offer a Roth option. He originally made $75,000 of pre-tax contributions and $50,000 of after-tax contributions. He retires and rolls over his assets to a traditional IRA and a Roth IRA. The basis in the 401(k) stays equal to the amount of after-tax contributions made: $50,000. Now, Charles can allocate $200,000 of pre-tax money to his traditional IRA and $50,000 of after-tax money to his Roth IRA—even if his income is too high to otherwise permit a Roth contribution.

Way to Boost Roth IRA Contributions--Even If Your Income is Too High Otherwise

Charles’s story shows why it normally is a bad deal to make after-tax 401(k) contributions while working. If you are a long way from retirement, you’ll get many years of growth, and all the growth on after-tax contributions will be taxed like pre-tax contributions when you make withdrawals when you retire.

But it does work for some. The ability to roll over after-tax contributions into a Roth IRA tax-free lets you funnel money into your Roth through the back door when the front door is nailed shut.

You can potentially add much larger amounts than the normal Roth limit, currently $5,500 annually, or $6,500 for people over age 50. Depending on what your employer’s retirement plan allows regarding the amounts and types of contributions, this change could prove a major boon.

Let’s say Jean is a 60-year-old single person who makes $200,000 this year. She plans to retire at 62. Because she has more than $129,000 of modified adjusted gross income, she can’t contribute to a Roth IRA.

Her employer’s 401(k) plan allows for a maximum 20% contribution, or $40,000, but only $17,500 of it is pre-tax. Until recently, it wouldn’t have made sense for Jean to contribute the remaining $22,500 after tax.

Now, she might want to. Since she can plan on rolling it over into a Roth IRA later, she can secure the Roth IRA’s powerful tax advantages today. (And even if her income is low enough to let her contribute to a Roth, she’ll be able to salt away more than $5,500 a year.)

While many employer plans accept after-tax contributions, this strategy will not make sense for everyone. Your age will be a large factor, because the length of time a contribution will grow in a given account may make it a more or less attractive option. If you’re going to retire fairly soon, the strategy may be a good choice.

In addition, you should consider the likelihood that you will remain in a similar tax bracket in retirement to that which you occupied while working. If you expect to drop to a lower one, or to move to a more tax-friendly state, you should consider your options in light of these long-term plans.

If your employer plan includes a Roth 401(k) option, definitely use it instead of making other after-tax contributions. With it, all your contributions will grow tax-free, as they do in an individual Roth IRA.

Eric Meermann, Certified Financial Planner (CFP®) is based in Palisades Hudson’s Scarsdale, NY, headquarters. He can be reached at eric@palisadeshudson.com Palisades Hudson (is a fee-only financial planning firm and investment advisor with more than $1.3 billion under management. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office and business management, tax preparation, and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, Fla., and Portland, Oregon. Read the firm’s daily column on personal finance, economics and other topics at http://palisadeshudson.com/current-commentary. Twitter: @palisadeshudson.