Retirement alchemy: Turn after-tax contributions into Roth savings

By Kevin Theissen
Skygate Financial Group LLC

In medieval times, alchemists sought methods for transforming ordinary metals into gold. Today, just about every adult searches for a means of transforming savings into a retirement’s worth of income. Recently, they received help from an unexpected source – the Internal Revenue Service.

In 2014, our nation’s tax collection agency engaged in a bit of retirement alchemy when it issued Notice 2014-54. Despite being tagged with an uninspired moniker, the notice gave participants in employer-sponsored retirement plans an opportunity to turn after-tax contributions into Roth retirement savings.

The new IRS rules benefit everyone, but they are particularly valuable to highly compensated individuals who cannot participate in Roth IRAs because of income limits and who cannot save as much as they would like in designated Roth accounts because of contribution limits.

After-tax contributions offer a way to save more

After-tax contributions have been the ordinary metal of retirement plan contribution options for decades. Both pre-tax and designated Roth options offer more attractive benefits.

• Pre-tax contributions: Immediate tax break; any earnings grow tax-deferred; and are taxed as ordinary income when distributed.
• Designated Roth contributions: No immediate tax break; any earnings grow tax-free and distributions are tax-free (as long as the account has been open for at least five years), and the account owner is age 59½ or older, is disabled, or has died.
• After-tax contributions: No immediate tax break; any earnings grow tax-deferred; and are taxed as ordinary income when distributed.

Despite their lesser benefits, a percentage of plan participants choose to make after-tax plan contributions because it allows them to set aside significantly more savings for retirement. In 2016, participants can save up to $53,000, or 100 percent of income, in a single employer’s retirement plan. That limit rises to $59,000 for participants who are age 50 or older and are making catch-up contributions.

The entire $53,000 cannot be directed to a single type of contribution. In 2016, assuming no employer contributions are made, participants can contribute up to:

• $18,000 total to pre-tax and designated Roth accounts;
• $6,000 additional to pre-tax and designated Roth accounts, if the participant is age 50 or older; and
• $35,000 to after-tax accounts, if the employer’s plan allows these contributions.

The IRS turns after-tax contributions into retirement gold

IRS Notice 2014-54 clarified IRS policy regarding the rollover of savings from after-tax plan accounts to Roth IRAs. Starting in 2015, when participants retire, change employers, or experience another ‘triggering event,’ they can rollover after-tax amounts to Roth IRAs and pre-tax amounts (including any earnings in after-tax accounts) to Traditional IRAs. After the conversion is complete, any earnings in the Roth IRA grow tax-free and qualified distributions are tax-free.

For example, assume a participant is 45 years old and makes the highest possible pre-tax ($18,000) and after-tax contributions ($35,000) to a 401(k) plan for five years. During the fifth year, she changes employers, which gives her an opportunity to rollover the $175,000 contributed to her after-tax account into a Roth IRA.

Any earnings in this account would accumulate tax-free. The assets in her pre-tax account and the pre-tax earnings from her after-tax account would rollover into a Traditional IRA. Any earnings in this account would accumulate tax-deferred until distributed.

An alternative option: In-plan Roth rollovers

If an employer-sponsored plan offers designated Roth and after-tax deferral options, and allows in-plan Roth rollovers, then participants may be able to amplify the benefits of a Roth conversion. One expert explained in-plan Roth rollovers:

“…allow participants to convert their non-Roth account balance (including pre-tax elective deferrals, matching contributions, and after-tax contributions) such that Roth characterization applies thereafter (i.e., no tax on future earnings). Any taxable portion of the converted amount (such as pre-tax elective deferrals and matching contributions, or earnings attributable to non-Roth after-tax contributions) will be subject to income tax in the year of conversion. An in-plan Roth rollover, however, will not trigger an early distribution penalty (provided the amount converted remains in the plan for at least five years).”

In-plan conversions give plan participants an opportunity to accumulate significantly more assets in designated Roth accounts than they would be able to otherwise. In addition to the $18,000 participants are allowed to contribute under IRS limits, they can rollover up to $35,000 from after-tax accounts each year. Any earnings have the opportunity to grow tax-free over a longer period of time and may be distributed tax-free.

If you have been contributing the maximum to your 401(k) plan and would like to save more, talk with your plan sponsor and financial professional about whether Roth rollovers may be right for you.