Advantages of a Rollover of After-Tax Contributions to a Roth IRA

On September 18, 2014, the IRS issued new guidance that makes it easier to rollover any After-Tax contributions that are included in 401(k), 403(b) or 457(b) plans directly to a Roth IRA.

Example: In order to explain the new guidance, it would be helpful to use an example. So our taxpayer, Mary, has a 401(k) account with her employer that identifies subaccounts for her. One subaccount is her Before-Tax account which consists of her pre-tax contributions that she made up to the allowable limit each year ($17,500 for under age 50/$23,000 for 50+ in 2014), her employer’s matching contributions and the investment earnings on these contributions. The other subaccount is her After-Tax account which consists of her contributions in excess of the allowable limit and the investment earnings on such contributions. Mary has $1,000,000 in her total account and the Before-Tax account is $750,000 and the After-Tax account is $250,000, which consists of $200,000 of Mary’s contributions and $50,000 of investment earnings. Mary is retiring at 62 and wants to rollover her account and maximize her after-tax retirement income. She does not need any of the income from her account because of her other sources of income.

What is the best way for Mary to maximize her after-tax retirement income?

The best solution for Mary is to roll over the $800,000 ($750,000 in Before-Tax account and the $50,000 of investment earnings in the After-Tax account) to a Traditional IRA and the $200,000 to a Roth IRA. Before the new IRS guidance there was a very complicated process to get money into the two IRAs, involving withholding taxes on a portion on the taxable money and not being able to get all of the $200,000 into a Roth IRA. The new guidance allows Mary to specifically advise her employer that she wants to allocate the distribution and have $800,000 go to her Traditional IRA and the $200,000 of her After-Tax contributions go to her Roth IRA.

What are the tax consequences of Mary’s Traditional IRA?

Mary’s traditional IRA will grow on a tax-deferred basis. She will have to start taking required minimum distributions after age 70 ½ and the distributions will be considered taxable income. Because of this taxable income, Mary’s tax bracket will increase and part of her social security will also become taxable income. Mary could have contributed the $200,000 to her Traditional IRA. If the $200,000 generated investment earnings of $100,000 in the IRA, the $100,000 will be taxable income when it is distributed.

What are the advantages of rolling the $200,000 to the Roth IRA?

Mary’s Roth IRA will grow on a tax-free basis. She does not have to take any required minimum distributions from her Roth IRA. She can let it continue to grow until she needs the funds. If the account grows to $400,000 and she needs the funds after age 85 she can start to withdraw the funds and pay no income taxes on the withdrawals. If she does not need the funds she can pass the account to her heirs who will pay no taxes on any withdrawals. In order for the investment income on the $200,000 to come out on a tax-free basis the account needs to be established for five years before the distribution of investment income.  There is no income limit required to do this rollover, unlike the income limits ($114,000 for single and $181,000 for married in 2014) that apply when you contribute to a Roth IRA.