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IRS Offers A Direct Path To Greater Savings

glasses resting on a document titled 'Retirement Plan'
photo courtesy American Advisors Group (AAG.com)

Financial advisers and tax professionals are a concrete bunch. We never like having to guess, and we don’t much care for having to take a roundabout path to accomplish a goal, either.

When the Internal Revenue Service leaves a situation vague, however, sometimes guesswork is unavoidable. While an announcement that the IRS has clarified a rule may not be headline-making news to most Americans, advisers tend to breathe a sigh of relief when the clarification cuts a new, direct path instead.

IRS Notice 2014-54 provides such a clarification for professionals. For many retirement savers, it also opens a door to a powerful contribution strategy that may change the way they look at their employers’ retirement plans.

Prior to the IRS’ recent notice, a worker whose retirement plan included both pretax and after-tax contributions faced a confusing situation when retiring or changing jobs. There are, for the purposes of this discussion, three possible places an account holder’s job-related retirement savings can go: a traditional IRA, a Roth IRA or a distribution directly to the account holder. Each of these destinations has benefits and drawbacks. But getting from point A to point B was formerly tricky for workers who had contributed both pretax and after-tax money to their employer’s plan.

Formerly, the IRS would treat simultaneous distributions, no matter the destination, as one distribution that included a pro rata share of the after-tax and pretax contribution amounts. In this way, each distribution duplicated the proportions of pre- and after-tax money in the overall employer retirement plan. If these payments were sent to traditional IRAs, investment earnings produced by after-tax dollars were simply tax-deferred, and would eventually be taxed at ordinary income rates (rather than at more beneficial capital gains rates). If payments were sent to Roth IRAs, the account holder had to pay pro rata taxes on the pretax portion of the transfer. Separating pretax and after-tax portions of each distribution was possible but complicated, and required convoluted methods about which not all professionals agreed.

The new notice makes things much clearer. The IRS now allows an account holder to break apart the separate “blocks” of contributions when choosing where to send them, as long as the distributions are made at the same time. The after-tax contributions can be rolled directly into a Roth IRA; pretax contributions can be rolled into a traditional IRA or distributed directly.

There are several reasons you should consider the implications of the new rules carefully.

For instance, when you choose how to roll over your 401(k) or other qualified retirement plan, especially if you have just retired, the new rule ensures that you can avoid rolling any portion of your after-tax contributions into a traditional IRA, where any growth will be taxed at ordinary income rates when distributed. Capital gains rates, which would apply to any growth if you simply took a distribution and reinvested the after-tax contributions elsewhere, are generally lower and a better option for contributions on which you have already paid tax. Because you can now direct rollovers to different accounts for contributions of different types, you can match the tax character of the contributions to the retirement account that treats them most favorably.

For example, Charles participates in his employer’s 401(k) plan, which does not include a Roth component. His balance is $250,000, made up of $200,000 in pretax contributions and $50,000 of after-tax contributions. He retires and chooses to roll over $100,000 to two retirement accounts: a traditional IRA and a Roth IRA. In the past, the distribution to each account would be assumed to comprise 80 percent pretax and 20 percent after-tax contributions, meaning Charles would need to pay pro rata taxes on a portion of the rollover to the Roth IRA or take a variety of steps to split up the distribution. The new ruling clarifies that Charles may allocate $80,000 of entirely pretax money to the traditional IRA and $20,000 of completely after-tax money to the Roth IRA. The rules governing the proportion are the same, but the way that Charles can direct them is now clear and beneficial to the taxpayer.

The new rules could have an even bigger upside: They could potentially make after-tax contributions to your 401(k) during your working life much more appealing than they have been in the past. The ability to roll over after-tax contributions into a Roth IRA without paying pro rata taxes on the distribution creates a form of back-door Roth IRA contributions, with the potential to add much larger amounts to the account than currently allowed under the annual limit (currently $5,500, or $6,500 for people over age 50).

Depending on what your employer’s retirement plan document allows as far as the amounts and types of contributions you can make to your plan, this change could prove a major boon.

It could work like this. Say Jean earns a salary of $200,000 annually. Her employer’s 401(k) plan allows for a maximum 20 percent contribution, or $40,000 a year. However, current 401(k) plan limits cap her maximum pretax deferral at $17,500. In the past, it would have made little sense for Jean to contribute the remaining $22,500 to her 401(k) after tax; she would have done better to simply take the money home and invest it herself. She could have added $5,500 to a Roth IRA and put the remaining $17,000 in a variety of different vehicles. Now, however, if she chooses to make the remaining $22,500 of possible after-tax contributions, Jean can plan on rolling it over into a Roth IRA later, thereby securing the beneficial character of the Roth IRA for much more of her income than she could have by direct contributions alone.

This strategy will not make sense for everyone, of course. Your age will be a large factor, because the length of time a contribution will grow in a given account may make it a more or less attractive option. In addition, you should consider the likelihood that you will remain in a similar tax bracket in retirement to that which you occupied while working. If you expect to drop to a lower one, or to move to a more tax-friendly environment, you should consider your options in light of these long-term plans. And if your employer plan includes a Roth 401(k), it makes sense to use that rather than after-tax contributions; in that case, the earnings will also be tax-free Roth money.

While the new rules don’t affect everyone, they are an overall win for taxpayers, as well as for the professionals who help them. A little bit of clarity can go a long way.

Vice President Eric Meeermann, who is based in our Stamford, Connecticut office, is the author of several chapters in our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 11, "Social Security And Medicare"; Chapter 18, "Philanthropy"; and Chapter 19, "A Second Act: Starting A New Venture." He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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