Last week the IRS issued IRS Notice 2014-54. After years of fighting taxpayers about certain types of IRA rollovers they finally gave in. Today we will discuss what led to this rule change and how it might affect your retirement savings.
Most 401K plans today allow for three different types of contributions. The most popular is the pre-tax contribution. These funds go into your account on a tax-free basis and are included as ordinary income when you withdraw them in retirement. The next is the Roth contribution where you pay taxes today, but withdraw earnings and principal tax free. The final, and least used, is the after-tax contribution, which are taxed today. Your principal comes out tax free upon withdrawal, but earnings are considered ordinary income.
Since earnings are taxed as ordinary income upon withdrawal for after-tax 401K contributions, most choose to invest these funds in a normal taxable account allowing for lower long-term capital gains tax rates. Things changed in 2006 with the Pension Protection Act. This allowed for the first time a direct rollover from your 401K to a Roth IRA. This was meant to be used for people who wanted to convert their pre-tax contributions to a Roth IRA, but some taxpayers started taking their after-tax money inside their 401K and rolling it over to a Roth IRA. This is beneficial since earnings in a Roth IRA are tax-free. Most high earners are not eligible to contribute to a Roth IRA (phase outs start at $181,000 for Married Filing Jointly (MFJ) and $114,000 for Single) and only $5,500 per year can be contributed ($6,500 for people over 50). With the Pension Protection Act, you can contribute after-tax dollars to your 401K with the intention of rolling it over into a Roth IRA at a later time.
The IRS had a problem with this because of the pro-rata rule for withdrawals from retirement accounts. It says that any withdrawal must be done in proportion to the pre-tax/after-tax ratio. For example, if you had a $1,000,000 401K account with $100,000 comprising of after-tax contributions and you tried to roll that $100,000 into a Roth IRA, the IRS’ position was that $90,000 of that rollover is pre-tax and $10,000 is after tax: consistent with the 90% pre-tax / 10% after-tax ratio of the $1,000,000 401K. After the $100,000 rollover, you would be left with $810,000 in pre-tax money and $90,000 in after tax money in your 401K. This defeats the purpose of making the rollover in the first place!
Since 2006 there have been many strategies for getting around the pro-rata rule. It seemed every time the IRS issued a new notice disallowing a specific strategy, a new strategy would take its place. There was always a risk, however, that these new strategies would not stand up in court. But with IRS Notice 2014-56 issued in September, the IRS capitulated, and these types of rollovers can now be done without the threat of challenge from the IRS.
There are still many nuisances to the rules regarding rolling over of after-tax 401k contributions to Roth IRA accounts, but the new rules definitely make this type of contribution a better deal. Let’s take a look at a couple of examples.
A 40-year-old Delta Air Lines First Officer makes $150,000 in 2014. He contributes the maximum to his 401K with a pre-tax contribution of $17,500. In addition, Delta contributes 15% of his earnings to the 401K for a total of $22,500. This leaves him with a total 401K contribution for the year of $40,000. If he wishes to save more for 2014 he can make after-tax contributions totaling $12,000 to get him to the maximum 415(c) limit of $52,000.
Later, at age 60, he separates from Delta and rolls his 401K into two separate accounts. A traditional IRA will receive his pre-tax contributions, pre-tax earnings and after-tax earnings. A Roth IRA will receive his after-tax contributions. Once he satisfies the rules for a Roth IRA he can now withdraw his contribution and earnings from his Roth IRA tax-free. This can be a powerful tax planning opportunity with different sources of pre-tax and after-tax funds.
A 55-year-old Delta Air Lines Captain makes $250,000 in 2014. He contributes the maximum to his 401K with a pre-tax contribution of $17,500. In addition Delta contributes 15% of his earnings to the 401K of $37,500. This makes a total contribution to the 401K of $55,000 which is over the 415(c) limit of $52,000. What would happen in this case is the first $34,500 of Delta’s contribution would go into the 401K filling it to $52,000 limit, then the remaining $3,000 would become ordinary income. In addition he elects to contribute $5,500 in catch-up contributions since he is over 50. In total he has saved $57,500 to his 401K for the year and received an extra $3,000 in ordinary income. In this case he is not allowed to contribute after-tax contributions to his 401K since he has already reached his 415(c) limit for the year.
In short, this new IRS notice makes contributing after-tax money to your 401K a great deal once you have maxed out your pre-tax or Roth contributions. This assumes, of course, you have room under the 415(c) limit to make these contributions.