New Rules for Rolling Over After-Tax 401(k)s

New IRS rules make it easier for higher-income workers to shift their money to Roth IRAs.

The rules apply to people who make after-tax contributions to 401(k) plans. These are contributions that exceed the maximum allowed tax-deferred contribution. You can make contributions above the tax-deferred ceiling, but the excess can’t be excluded from gross income. That portion of the  salary is included in gross income and subject to income and payroll taxes.

The after-tax contributions aren’t taxed when withdrawn, whether they are withdrawn directly from the 401(k) or from an IRA the 401(k) was rolled into. But before the new rules, workers had to follow complicated rules to roll the after-tax contributions into Roth IRAs, and for many the rules were a deterrent to even trying.

The new rules make it easy for higher-income workers to accumulate substantial Roth IRA balances. This is important, because higher-income taxpayers aren’t allowed to make contributions to Roth IRAs at all. Once adjusted gross income exceeds $191,000 for a married couple filing jointly ($128,000 for individuals), Roth IRA contributions simply aren’t allowed.

Now, a worker can make tax-deferred 401(k) contributions and then make additional after-tax contributions up to a maximum total of $52,000 ($57,500 for workers 50 and over) in 2014. (Though the “top-heavy” rules could reduce those limits. Later, the after-tax contributions can be rolled over directly to a Roth IRA. The only catch is that the direct rollover is allowed only when the pre-tax savings in the 401(k) also are rolled over to a traditional IRA at the same time. The new rule is an opportunity for workers to substantially increase the amount they’ll have in Roth IRAs and have tax diversification during retirement.

RW December 2014.