I recently joined a group of other like-minded financial advisors from around the country whose purpose is to share great content and spread the word about the virtues of Fee-Only financial advice. The first in this series of articles is written by Greg Phelps of RedRock Wealth Management from Las Vegas. He wrote an article about how to turn your 401(k) contributions into a Roth IRA. Greg really knows his stuff so if you are ever in Las Vegas I suggest you reach out to Greg for more financial tips. Here's the Article:
Most savers are well aware of the pre-tax nature of 401k plan contributions. Some are even aware of how the Roth 401k contribution works. Fewer still understand that after-tax 401k contributions may be one of the best ways to save for retirement yet!
Here’s a quick recap of how these three types of 401k contributions work:
Pre-tax 401k contributions
You contribute money into your 401k prior to it being taxed. This lowers your current tax liability and your investment grows tax-deferred until it’s withdrawn. Assuming you play by the rules, you’ll simply pay ordinary taxes when funds are distributed either from your 401k plan or an IRA rollover.
Roth 401k contributions
You contributed money into your 401k Roth account AFTER taxes have been paid. You pay more in taxes now, but your investment again will grow tax deferred and assuming you play by the rules you’ll never pay taxes on any distributions.
After-tax 401k contributions
You contribute money into your 401k plan AFTER taxes have been paid. You get no current tax deduction, and while your investment growth is tax deferred it is taxable as ordinary income when you withdraw it. You do however accumulate “basis” in these contributions, and your original principal can be distributed tax free. This is assuming you play by all the rules.
The after-tax 401k strategy
We’re talking strategy here, as we do with all of our retirement financial planning clients in Las Vegas. Since we’re talking high level strategy we’re not going to dig into the minutia of the rules, but suffice to say your 401k plan is a retirement account so you should have no problems achieving the simple withdrawal hurdles the IRA imposes.
IRS Notice 2014-54 is fairly new, so you may not be aware of this wonderful rule. Let’s assume for a moment you’re in a fairly high income tax bracket - say 25% plus. You really enjoy the pre-tax 401k contributions because they immediately lower your tax liability. But what if you don’t need the income to live on? What if you want to save more than the normal $18,000 pre-tax maximum (for 2016)?
Prior to IRS 2014-54 if your 401k plan allowed for after-tax voluntary contributions above the normal pre-tax limits you would have made them establishing “basis” in your 401k plan. Essentially since you didn’t get a tax break on the contribution, the amount would also be distributed tax free. This wasn’t so bad, because when the 401k plan funds rolled over into an IRA that basis carried with it and the basis can be withdrawn tax free.
The growth on those after-tax contributions however enjoyed tax deferral, but not tax-free withdrawals. So the growth would still still be taxed at ordinary income rates.
Along comes 2014-54
The IRS finally gave in after years of battling this issue. People complained their after-tax voluntary contributions should be treated as Roth contributions, however the “pro-rata” rule didn’t allow for that. The pro-rata rule said that just like when you put creamer into a cup of coffee, you can’t get it out unless it’s proportionate. In this same vane, putting after-tax contributions into a 401k plan required that all distributions would be proportionate and partially tax-free and partially taxable.
The recent ruling changed that. The recent ruling now allows your after-tax 401k contributions to be separated from your pre-tax contributions upon distribution. This effectively makes those after-tax contributions effectively the same as Roth contributions because the astute investor would clearly opt to roll those monies into a Roth IRA, and their pre-tax contributions into a regular rollover IRA.
What does all of this after-tax Roth contribution stuff mean?
This all means that if your plan allows for voluntary after-tax contributions above the normal limits (subject to the ultimate annual defined contribution plan limit ($53,000 plus catch-up of $6,000 if you’re 50 or older) and you can afford it - you should do it! If you’re in higher tax brackets (as mentioned 25%+), max out your $18,000 in pre-tax contributions (plus the catch-up contribution if eligible. After that put as much after-tax voluntary contribution into your plan as possible (again, subject to the annual additions limits).
When you terminate employment you’ll have the option of rolling those funds into separate pre-tax and Roth IRA’s. The amounts contributed on an after-tax basis will go into your Roth IRA, and all growth plus pre-tax contributions will roll into a regular IRA. The end game is you’ll have a nice sized Roth IRA to go along with your pre-tax IRA’s - allowing you greater tax smoothing of your retirement income when you ultimately stop working.
About the Author
Greg Phelps, CFP®, CLU®, AIF®, AAMS® - with his 20+ years of experience and extensive credentials - is one of the top financial planners in Las Vegas with Redrock Wealth Management. He started in the financial services field in 1995, and became a fee-only fiduciary in 2002 prior to founding Redrock in 2005. If you’re in the local Las Vegas or Henderson area, look him up! He’d be happy to share a cup of coffee and chat about financial planning with you.