Can after-tax money in a traditional 401(k) be moved directly to a Roth IRA tax free? For years, IRS guidance left the answer murky, causing financial advisers to offer conflicting advice.
Now the IRS has finally cleared things up: Taxpayers can now split after-tax money from a traditional 401(k) and send it directly to a Roth. The ruling makes life easier for retirees, while also helping them boost tax-free savings. "It's a sweet deal," says Mike Piershale, president of Piershale Financial Group, in Crystal Lake, Ill.
Beware, though, that few company plans accept after-tax contributions in a traditional 401(k). Each company plan sets its own rules and doesn't have to offer all the features the IRS blesses. In his experience, Ryan Sullivan, a financial planner in the Traverse City, Mich., office of Rehmann Financial, estimates that about 10% of the thousand plans his company works with allow after-tax contributions. But with this new rule, he says, that number could grow.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Ask your plan's administrator to spell out the features your plan offers. "The stars have to align," says Jeffrey Levine, IRA technical consultant for Ed Slott and Co., which provides IRA advice. If they do, he says, this is a "powerful strategy."
Say you have a traditional 401(k) worth $100,000, holding $80,000 of pretax money and $20,000 of after-tax money. Perhaps you're retiring and you want to roll the money out of the plan. The IRS will now let you transfer the pretax $80,000 directly to a traditional IRA and the after-tax $20,000 to a Roth IRA. The cost of this move: zero.
While it has been easy to roll Roth 401(k) money to a Roth IRA tax free, that hasn't been the case with after-tax money in a traditional 401(k). Before the IRS ruling, you could roll the money into a traditional IRA and a Roth IRA, but you would get hit with a tax bill because pro rata rules would apply. You would owe income tax on the money going to the Roth based on the ratio of pretax money to the total 401(k) assets -- in this case, 80% of the total.
If you moved $20,000 to a Roth, only 20% of it would be considered after-tax money and therefore tax free; the rest would be considered pretax money. So $16,000 would be taxed, triggering a $2,400 bill in the 15% bracket. Money could be converted from the traditional IRA holding the $80,000, but only a portion of each conversion would be tax free because under the old rules just part of the traditional IRA would be made up of after-tax money. Under the new ruling, "you can experience a Roth conversion without having to pay taxes for a Roth conversion," says Sullivan.
But even with the new rule, you "can't just pull out the after-tax money," says Levine. Say you want to take $50,000 from the $100,000 401(k). Only 20% -- or $10,000 -- would be considered after-tax money and could go directly to a Roth IRA tax free.
Boost Tax-Free Savings
High earners who want to turbocharge tax-advantaged savings should take note of the new IRS rule. "It's a great planning opportunity for people who can't contribute to a Roth IRA," says Sullivan, if their plan allows it. For 2014, the ability to contribute to a Roth IRA phases out for single filers at $129,000 of modified adjusted gross income and for joint filers at $191,000.
There are no income limits on converting a traditional IRA to a Roth IRA, but generally conversions come with a tax bill. And while high earners can make nondeductible contributions to a traditional IRA and then convert that money to a Roth, traditional IRA contributions are limited to $5,500 a year for 2014 (plus an extra $1,000 if 50 and older).
Instead, you could load up your 401(k) with after-tax contributions. Pretax contributions are capped at $17,500 for 2014 (plus an extra $5,500 if 50 and older), but the total contribution limit is $52,000 for 2014, or 100% of compensation, whichever is less. That overall limit includes all employee and employer contributions.
The after-tax money will grow tax-deferred in the 401(k). At distribution time, that after-tax money can be split off into a Roth IRA to grow tax-free while earnings and pretax contributions go to a traditional IRA. "If you're looking for more places to save money, this is a great place to do it," says Sullivan.
-
Here's How To Get Organized And Work For YourselfWhether you’re looking for a side gig or planning to start your own business, it has never been easier to strike out on your own. Here is our guide to navigating working for yourself.
-
How to Manage Risk With Diversification"Don't put all your eggs in one basket" means different things to different investors. Here's how to manage your risk with portfolio diversification.
-
457 Plan Contribution Limits for 2025Retirement plans There are higher 457 plan contribution limits for state and local government workers in 2025 than in 2024.
-
What Does Medicare Not Cover? Seven Things You Should KnowHealthy Living on a Budget Medicare Part A and Part B leave gaps in your healthcare coverage. But Medicare Advantage has problems, too.
-
13 Smart Estate Planning Movesretirement Follow this estate planning checklist for you (and your heirs) to hold on to more of your hard-earned money.
-
Medicare Basics: 11 Things You Need to KnowMedicare There's Medicare Part A, Part B, Part D, Medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare — and much more.
-
The Seven Worst Assets to Leave Your Kids or Grandkidsinheritance Leaving these assets to your loved ones may be more trouble than it’s worth. Here's how to avoid adding to their grief after you're gone.
-
SEP IRA Contribution Limits for 2024 and 2025SEP IRA A good option for small business owners, SEP IRAs allow individual annual contributions of as much as $69,000 in 2024 and $70,000 in 2025..
-
Roth IRA Contribution Limits for 2024 and 2025Roth IRAs Roth IRA contribution limits have gone up. Here's what you need to know.
-
SIMPLE IRA Contribution Limits for 2024 and 2025simple IRA The SIMPLE IRA contribution limit increased by $500 for 2025. Workers at small businesses can contribute up to $16,500 or $20,000 if 50 or over and $21,750 if 60-63.
