If you are getting close to retirement, have been making contributions to a 401(k) plan, and fall into the highly compensated employee (HCE) category, there is an IRA rollover technique that may “pay” tax-advantaged “dividends”. The IRS has specific rules about how participants such as you can allocate accumulated 401(k) plan assets based on pre-tax and after-tax employee contributions between standard IRAs and Roth IRAs.
Highly Compensated Employees and After-Tax Roth IRA Contributions
In 2017, the greatest pre-tax contribution that participants can make to a 401(k) is $18,000 (or $24,000 for those 50 and older) per year. Plans that permit after-tax contributions (which several do) allow participants to contribute a total of $54,000 ($36,000 above the $18,000 pre-tax contribution limit). While some highly compensated individuals may make significant after-tax 401(k) contributions, tax law income caps prohibit the highest paid HCEs from opening a Roth IRA.
However, under IRS rules, these participants are permitted to roll these after-tax 401(k) contributions directly into a new Roth IRA once they retire or no longer work for the company. By doing this, these HCEs will ultimately be able to withdraw the dollars representing their original after-tax contributions — and subsequent earnings on those dollars — tax-free.
Contributions in Action: An Example
Participants can contribute rollover dollars to conventional and Roth IRAs on a pro-rata basis. For example, suppose a retiring participant had $1 million in his 401(k) plan account, $600,000 of which is derived from contributions that participant made. Let’s also assume that 70% of that $600,000 represents pre-tax contributions, and 30% represents after-tax contributions. IRS guidance clarifies that the participant can roll $700,000 (70% of the $1 million) into a conventional IRA, and $300,000 (30% of the $1 million) into a Roth IRA.
The IRS rules allow the retiree to roll over not only the after-tax contributions, but the earnings on those after-tax contributions (40% of the $300,000, or $120,000) to the Roth IRA provided that the $120,000 will be taxable for the year of the rollover.
Alternatively, the IRS rules allow the retiree to delay taxation on the earnings attributable to the after-tax contributions ($120,000) until the money is distributed by contributing that amount to a conventional IRA, and the remaining $180,000 to the Roth IRA.
Using either approach, the subsequent growth in the Roth IRA will be tax-free when withdrawn. Partial rollovers can also be made, and the same principles apply.
HCEs face some complex decisions when it comes to retirement planning so be sure to contact your Untracht Early advisor for help in planning what would work best for you.