After-tax 401(k)s just got a tax break.
Pretax 401(k) contributions are not the only game in town. Many plans also permit after-tax contributions — 62 percent, in fact, according to The Plan Sponsor Council of America's 56th Annual Survey of Profit Sharing and 401(k) Plans. That figure includes both Roth 401(k)s and "after-tax 401(k)s." The survey reports on the 2012-plan-year experience of 686 plans with 10.3 million participants and $769 billion in plan assets. The average account balance, including both pretax and after-tax balances, is roughly $98,000.
Contributions to after-tax 401(k)s don't affect your W-2. That is, the taxable income on your W-2 is not reduced, unlike pretax contributions, as we discussed last week.
But after-tax contributions may offer some advantages. For example, anyone can contribute to an after-tax 401(k), irrespective of income. That's not the case with a Roth IRA that you set up on your own. As a result, higher earners won't qualify for a Roth IRA, but everyone qualifies for an after-tax 401(k).
One of the benefits of having an after-tax 401(k) is the ability to move that money into a Roth IRA after you leave your employer — or earlier, if your plan allows for in-service withdrawals.
However, until a few weeks ago, when the Internal Revenue Service issued Notice 2014-54, "Guidance on Allocation of After-Tax Amounts to Rollovers," there was some confusion as to the tax consequences of doing so.
As Peggy Riley, spokeswoman for the IRS, explained, it had appeared as if after-tax accounts were always taxed at least in part when they were transferred out of a 401(k) plan, even if they were transferred to a Roth IRA. The reason had to do with "destinations." It was not clear how to distribute after-tax money to a Roth and pretax money to a traditional IRA.
Riley confirmed the following, assuming you take a full distribution of your 401(k), including both pretax and after-tax. This applies to after-tax 401(k)s; Roth 401(k)s have different rules:
1) You can direct the pretax portion to your traditional IRA. Importantly, Riley points out the pretax 401(k) money includes earnings on the after-tax monies.
2) You can direct your after-tax portion to a Roth IRA.
3) The transfer of your after-tax 401(k) to your Roth IRA will NOT be subject to income tax.
4) You cannot cherry-pick just the after-tax portion. You need to do a full distribution of both pretax and after-tax monies.
5) If you have 401(k)s with multiple employers, you need to consider only the single 401(k) in question. You do not need to add the other 401(k)s.
Different rules apply to partial distributions. Here is an example from the IRS Notice for an employee who separates from employment:
In this case, only $100,000 of a $250,000 401(k) is distributed. The $250,000 is all pretax except for $50,000 of after-tax accounts.
Now you need to do some math. Since $200,000 is pretax, you divide $200,000 by the total ($250,000) to come up with a fraction ($200,000/$250,000) representing the pretax portion of the distribution. If withdrawn, the pretax portion would be fully taxable.
Applying the fraction to the $100,000 distribution, you arrive at a figure of $80,000 as the pretax amount. The calculation comes from section 72(e)(8) of the Internal Revenue Code.
That leaves $20,000 of the $100,000 as after-tax money.
Instead of taking a withdrawal, Employee C makes a direct rollover of $80,000 to a traditional IRA, and importantly, he can transfer the $20,000 after-tax money to a Roth IRA.
Quoting directly from the IRS Notice: "Employee C is permitted to allocate the $80,000 that consists entirely of pretax amounts to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after-tax amounts."
The significance of these changes is huge if you do a full distribution. Before, it was unclear whether you could direct after-tax money from your 401(k) in this fashion. Now on a full distribution, you can direct your after-tax money to a Roth IRA, and it won't cost you a dime in taxes.
Julie Jason, JD, LLM, a personal money manager (Jackson, Grant of Stamford, Conn.) and award-winning author, welcomes your questions/comments (readers@juliejason.com).