by James B. Tharin, CFA
If you are planning to retire or change jobs and you have an investment in a qualified retirement plan like a 401k, the IRS might have just given you a gift. Or at least they might have made your life a little easier. Recent guidance from the IRS (Notice 2014-54) states that after-tax dollars in a 401k can be rolled over into a Roth IRA for plan distributions taken on or after September 18th, 2014. This is a change from the old rules where participants only had the choice of taking the after-tax contributions as a distribution or rolling those after tax dollars into a Traditional IRA. The rollover of after-tax dollars into a Traditional IRA carried some tax advantages over taking direct receipt of the after-tax dollars but the rollovers were subject to the pro-rata rules.
The pro-rata rules can best be explained as follows. Previously, 401k participants could roll after-tax dollars into a Traditional IRA along with their pre-tax dollars. When distributions were ultimately taken from the Traditional IRA, the after-tax dollars had to be withdrawn on a pro-rata basis but the pro-rata portions of the distributions were tax-free. Those tax-free portions of the IRA distributions had to be accounted for and that could be confusing and time consuming. Furthermore, many people have actually forgotten that they ever rolled over after-tax dollars and have missed the tax break altogether.
Below is an example of how the rules have evolved. Suppose you have $1,000,000.00 in your 401k and 15% (or $150,000.00) of that $1,000,000.00 is made up of after-tax contributions. Before the new rule came into effect, 401k participants with after-tax contributions had two choices:
The first and most common choice was to take a check for the $150,000.00 (tax-free) and roll the remaining $850,000.00 into an IRA. The $850,000.00 would continue to grow tax deferred until distributions were taken and those distributions would then be subject to income taxes. The other $150,000.00 would be available to be spent, saved or invested, depending upon the participant’s needs and goals. However, any future tax advantages previously enjoyed through the retirement plan on the after-tax distribution would then be gone.
The second option was to roll the entire $1,000,000.00 into a traditional IRA. Because 15% of the rollover was with after-tax dollars (meaning taxes had already been paid on that portion of the savings), 15% of each distribution would be unencumbered by income taxes. Option two obviously requires attention to detail and meticulous record keeping.
The latest IRS guidance states that instead of following the pro-rata rules, qualified retirement plan participants can actually roll after-tax dollars directly into a Roth IRA. On the surface, the result appears to be the same as following the pro-rata rules. However, investors have some new advantages. First of all, investors who take advantage of the Roth option could gain more control over their taxes. As an investor’s tax rate changes, either due to income fluctuations or changes in the tax code, he or she can decide which account to use to fund income needs. In years where taxes are anticipated to be high it might make sense to tap the Roth IRA as opposed to the Traditional IRA for living expenses or large one time purchases. Secondly, an investor might opt to make the more conservative portion of their investments for their portfolio in the Traditional IRA and the more aggressive portion of their investments in the Roth IRA. That way, if the more aggressive investments do outperform the more conservative investments then there would be more money available for tax free distributions than if all investments were made in the same account. Thirdly, there is no Required Minimum Distribution (RMD) for a Roth IRA. Therefore, by lowering the size of the Traditional IRA relative to the size of the Roth IRA, RMDs could potentially be lowered.
There are lots of moving parts in this strategy and this article is not intended to be comprehensive so make sure you look at all of the angles. Also, since the tax code seems to be in a permanent state of change, always consult the advice of a qualified tax professional before taking any action. For more information check out the IRS’ website here: http://www.irs.gov/Retirement-Plans/Rollovers-of-After-Tax-Contributions-in-Retirement-Plans. Hopefully you now realize that investors have many items for consideration before they even start to shop for investments. So know your options!