April 7, 2015
by Michelle Perry Higgins
The Internal Revenue Service has issued a notice that permits a 401(k) rollover strategy starting this year—something it had been fighting for some time. This strategy opens up some valuable planning opportunities for current 401(k) participants.
First, a bit of background. Some 401(k) plans permit aftertax contributions by participants in excess of the pretax or deferral limit. For 2015, the pretax contribution limit is $18,000 with an additional $6,000 catch-up contribution for participants who are 50 years of age or older. After-tax contributions can be made up to an overall limit that combines pretax, aftertax and matching contributions. This overall limit is $53,000 for 2015.
Before the IRS notice, when participants left their employer they could not separate the 401(k) rollover into pretax and aftertax components with different IRA destinations for each. Each IRA would have to receive a pro rata portion of the pretax and aftertax components. The portion of the distribution to the Roth IRA would, therefore, contain both pretax funds and aftertax funds. This meant that the pretax contribution would have to be characterized as a Roth conversion amount and fully taxable. Obviously, this reduced much of the benefit of creating a separate Roth IRA account to contain a portion of the 401(k) rollover.
The new rule changes the pro rata requirement by allowing the participant to designate the particular IRA accounts to which rollovers of pretax or aftertax funds are sent. This means that a 401(k) participant with a value of $100,000 in their account that includes aftertax contributions of $25,000 can create a rollover IRA account and a Roth IRA account and direct the plan administrator to send $75,000 to the rollover IRA and $25,000 to the Roth IRA. The $75,000 in the rollover IRA will be deemed to be pretax money and the $25,000 in the Roth IRA will be deemed to be aftertax money. There will be no taxes due on the funds transferred to the Roth IRA as there is no conversion of pretax money.
This change provides a valuable planning tool to participants who are able to contribute more than the basic tax-deferred amount to their 401(k)s. By contributing aftertax money to their 401(k), they can avoid taxes on income from the aftertax contributions until the income is distributed due to need or required minimum distributions. And by being able to rollover the aftertax contributions to a Roth IRA upon retirement, income from investments in the Roth IRA are shielded from tax forever.