If you have access to a 401(k) plan, contributing at least the amount for which your employer will provide matching funds is one of the best ways to save for retirement. That has been true for some time. However, the IRS has just given you even more incentive to pack money into your 401(k).
You can exceed the basic limits with after-tax contributions.
Although one of the great appeals of a 401(k) plan is the deductibility of contributions you make, there is a limit to how much you can deduct in this way. If your employer’s plan allows it, after you have reached the limit on tax-deductible contributions to your 401(k) (currently $17,500 for those under 50 and $23,000 for workers 50 and older), you may choose to contribute after-tax earnings to the plan up to limits of $52,000 and $57,500, respectively. However, doing so was, until recently, of questionable value. Although the after-tax funds would grow tax-deferred, earnings would still be taxable upon withdrawal, and for many investors, other options have been more beneficial.
You can increase the power of those after-tax contributions by rolling them into a Roth IRA.
The IRS has recently sweetened the after-tax 401(k) contribution deal. You can now dramatically increase the tax effectiveness of those additional contributions by converting them to a Roth IRA, where they will grow tax free, rather than merely tax-deferred, and also be tax-free upon qualified withdrawal. Previously, it was debatable whether and how one could do this. The IRS recently clarified the questions surrounding these types of conversions in Notice 2014-54, which sanctions precisely this type of rollover.
You must carefully follow the rules to get maximum benefit from your conversion.
If you’re rolling over a 401(k) that contains, for example, 70% pre-tax and 30% after-tax contributions, you can split the rollover of those funds between a traditional IRA or new 401(k), which can accommodate the pre-tax funds, and a Roth for the post-tax portion of your retirement savings. However, the IRS demands absolute clarity of your intent at the time of the rollover. Notice 2014-54 states:
“…if the direct rollover is to two or more plans, then the recipient can select how the pretax amount is allocated among these plans. To make this selection, the recipient must inform the plan administrator of the allocation prior to the time of the direct rollovers.”
That means that it isn’t enough to say to your plan administrator, “Roll 70% into my traditional IRA and 30% into my Roth.” You must specify that you want all of your pre-tax dollars to go into the traditional IRA and all of your after-tax dollars to go to the Roth. Otherwise, the funds may be considered mixed; each allocated portion could be considered a 70/30 split of pre- and post-tax money, which could spoil this beautifully simple plan and subject you to additional tax burden.
Always consult with your professional financial advisor when considering how to roll over your 401(k). A qualified, independent professional can best advise you as to the optimal moves for your individual financial circumstances. Boelman Shaw specializes in tax and financial planning, including retirement planning. Contact our Des Moines office to discuss options for rolling over your 401(k).
Material discussed herein is meant for general illustration and/or informational purposes only. Because individual situations will vary, the information shared here should be used in conjunction with individual professional advice.