After Tax-Money in Company Retirement Plan: 5 Questions You Need Answered After IRS Notice 2014-54
By Jeffrey Levine, IRA Technical Expert
Follow on Twitter: @IRAGuru4EdSlott
Most people are familiar with the basic rules for the pre-tax salary deferrals and employer contributions that are the most frequent types of money found in 401(k) and similar plans. Many are also familiar with the special rules that apply to the designated Roth accounts, like Roth 401(k)s that are becoming more and more common within these same plans. Few, however, are aware of the rules for after-tax contributions to the “traditional side” of such plans and the unique rules and planning opportunities that can present themselves. In fact, there are many people who don’t even know these kinds of plan funds exist!
That’s begun to change over the last week, however, since the release of IRS Notice 2014-54, which provided exceptionally favorable guidance for people with after-tax money in their 401(k) and similar plans. As a result of the notice, if you have this type of money in your plan, you may be able to make a Roth conversion on a portion of your retirement savings, but without paying any tax!
But what exactly are after-tax contributions? Do they have any special rules? How do I know if this impacts me? The answer to these questions and more are below:
- Aren’t After-Tax Contributions The Same As Roth Contributions?
No, absolutely not. Although Roth contributions are made on an after-tax basis, when people talk about “after-tax” money in an employer plan, they are usually talking about funds contributed to the “traditional” side of the plan, but for which no tax break was received. The biggest difference between the two is the tax treatment when distributions are taken in future. While both Roth 401(k) salary deferrals and their earnings can be distributed tax-free (if part of a qualifying distribution), the gains earned on any after-tax contributions to the plan are generally taxable when distributed.
- Do All Plans Allow For After-Tax Contributions?
No. This is an option that is available to plans, but certainly not one they are required to incorporate. Many plans do not incorporate this option.
- Do The Same Contribution Limits That Apply to Pre-Tax and Roth Salary Deferrals Also Apply to After-Tax Contributions?
No. In 2014, the salary deferral limit for pre-tax and Roth salary deferrals to 401(k) and similar plans is $17,500. If you are 50 or older by the end of the year, you can contribute an additional $5,500, for a total of $23,000. After-tax contributions made to an employer plan are not subject to these limits.
In addition to the limit on salary deferrals, there is a lesser known rule called the “overall limit.” The overall limit for 401(k)s and similar plans for 2014 is $52,000, or 100% of compensation, whichever is less. The overall limit looks at the total annual additions to all of your accounts in plans maintained by one employer and includes not just your salary deferrals, but also matching contributions, allocations of forfeitures and other amounts.
IF your plan allows you to make after-tax contributions, you can – from a tax code perspective – make such contributions up to your overall limit for the year. For example, suppose you have a plan that allows you to make after-tax contributions. You plan on making a full $17,500 deferral to your Roth 401(k) and expect to receive $20,000 in employer contributions, for a total of $37,500 of additions to your plan for 2014. As such, assuming you have enough compensation to do so, you can contribute an additional $14,500 in after-tax funds to your plan ($52,000 overall limit - $37,500 of other additions) for 2014.
- Do The Same Distribution Rules That Apply To Pre-Tax and Roth Salary Deferrals Apply To After-Tax Contributions?
No. The rules are very, very, very (did I mention very?) complicated here but, for the most part, if you are still working for the company offering the 401(k) or similar plan, and you are under age 59 ½, access to your pre-tax salary deferrals, Roth salary deferrals and their earnings is incredibly limited. Once you leave your job or turn age 59 ½, that may change. The same restrictions on accessing plan funds, however, don’t apply to after-tax contributions and their earnings. Therefore, these funds may be fairly accessible (depending on your plan’s rules), even if you’re under age 59 ½ and still working for the company offering your 401(k).
- If I Have After-Tax Funds In My Employer Plan, How Does IRS Notice 2014-54 Impact Me?
The notice provides guidance regarding a number of transactions, but most importantly, it definitively answers one of the most hotly debated topics in the retirement community in recent years… “Can a person with pre and post-tax plan money directly rollover (convert) their after-tax money, tax-free, to a Roth IRA, while also directly rolling over their pre-tax money to a traditional IRA?” The IRS’ answer is an emphatic, “Yes.”
As a result, if you have any after-tax money in your 401(k) or similar plan, once you are eligible to take a distribution of those funds you should strongly consider using the basis allocation rules provided by Notice 2014-54 to make tax-free Roth IRA conversions of your after-tax plan assets. Of course, like always, there are a few potential traps and procedures to follow in order to make this transaction work as intended, so be sure to speak with your tax and/or financial advisor first.
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