Individual retirement accounts are among the most popular savings vehicles when putting money away for retirement.
When Congress created the Roth IRA in 1997, it quickly became a popular option because it enabled your retirement savings to grow tax free instead of just tax deferred. The big drawback is that the annual contribution limits are fairly low—only $5,500 per year if you’re under 50.
In 2006, Congress authorized 401(k) plans to begin offering a Roth 401(k) option, which essentially enjoys the same tax-free growth as the Roth IRA. The contribution limit for employees is higher, now allowing for 2015 Roth contributions of up to $18,000 into a Roth 401(k).
But what if a person would like to make additional retirement savings contributions to a Roth? In September 2014, the IRS issued Notice 2014-54, which essentially provides an opportunity to put up to the annual 401(k) plan contribution limit ($53,000 in 2015) away and treat it as a Roth IRA contribution.
Supersize your Roth
The possibility to put as much as $53,000 toward retirement tax free is a tremendous planning opportunity. Unfortunately, it’s one that probably won’t be feasible for everybody.
The first limitation is the amount of cash people can afford to set aside for retirement while still maintaining their current lifestyles. If you’re able to save the maximum contribution sum each year, then your next hurdle is whether your 401(k) plan allows participants to make after-tax contributions over and above the annual deductible thresholds and up to the annual defined contribution plan amount.
If you meet those criteria, the strategy works like this: During your working years, you will contribute to your 401(k) plan annually, maximizing the deductible or Roth 401(k) contributions each year. That limit in 2015 is $18,000 ($24,000 for those aged 50 and over). Then you will make additional after-tax contributions to your traditional 401(k) plan each year to bring your total contributions up to the annual limit, which in 2015 is $53,000.
When you retire, you then request a lump-sum distribution of your 401(k) plan, but instruct your plan administrator to issue two checks. The first check is for the total of all of your after-tax contributions. This check will be rolled directly into your Roth IRA. The second check is for the remaining balance in your 401(k) account and these funds are rolled directly into your traditional IRA. The end result is a tax-free rollover to your Roth IRA of all those years of after-tax 401(k) contributions and a tax-deferred rollover to your traditional IRA of your annual deductible contributions and earnings.
An example
Beginning in 2015, let’s say you defer $18,000 per year into a traditional 401(k) plan. You also contribute $35,000 in after-tax dollars to your traditional 401(k) plan, resulting in the maximum annual contribution of $53,000 per year.
For simplicity, we’ll assume you do this for 10 years and ignore any future increases in annual contribution limits. We’ll also assume that for each of those years you accumulate $20,000 of earnings/growth in the overall 401(k) account.
After 10 years, you retire with a balance in your 401(k) account of $730,000. You have $350,000 of after-tax contributions to your plan and you have $380,000 of pre-tax value made up of deductible contributions and earnings/growth on the account.
You instruct your plan administrator to distribute your entire plan balance in a lump sum, but issue two separate checks. The first check for $350,000 goes directly to your Roth IRA as a tax-free rollover. The second check for $380,000 goes directly to your traditional IRA as a tax-deferred rollover. You have effectively managed to make $350,000 in Roth IRA contributions in a 10-year period—not bad at all.
Key issues
In order to make this planning strategy effective, there are a few key items to keep in mind.
If a plan administrator doesn’t maintain separate subaccounts for after-tax contributions, the participant must liquidate their entire “account” to isolate tax-free contributions. A partial distribution would contain a mixture of taxable and tax-free distributions based on the ratio of those balances in the account.
If a plan administrator does maintain separate subaccounts for after-tax contributions, then the participant has the ability to distribute the entire after-tax subaccount, which would qualify as a tax-free rollover, and can elect to leave the tax-deferred dollars inside the 401(k) plan if desired.
It’s most advantageous to have the liquidating dis-tributions go directly from the 401(k) plan to the receiving IRAs. Taking possession of the distributions personally can potentially result in mandatory income tax withholding of 20 percent on the tax-deferred portion of the distribution.
Only the after-tax contributions are treated as after-tax dollars in the account, even if accounted for separately in a subaccount. Earnings are always tax-deferred unless in an actual Roth 401(k) account.
Your 401(k) plan will still need to adhere to the antidiscrimination tests specified under ERISA rules, which may limit the maximum annual contributions available for you.
In order to split apart your after-tax contributions and complete a tax-free rollover, you must make a full distribution of the account. Again, either the entire 401(k) account if subaccounts aren’t used, or just the after-tax contributions subaccount if it’s accounted for separately.
Priority retirement savings options
People are often unable to take advantage of the full annual defined contribution plan limit of $53,000. In that case, a common question is, “How do I prioritize which retirement savings option to use first?”
First, fund any retirement plan for which you receive a matching contribution and contribute sufficiently to maximize the match.
Then, fully fund either your Roth IRA and/or remaining deferrals available to a Roth 401(k)—if tax rates are low. Or you could fully fund a traditional 401(k) and a deductible IRA if possible (when a current tax deduction is preferred).
Finally, you maximize after-tax contributions to your traditional 401(k) plan if available.
While this strategy may not apply to everybody, it represents a powerful retirement planning tool that holds a lot of potential for many people. Regardless, it should trigger conversations with your 401(k) plan administrators to understand more clearly your retirement plan options. It also serves as a good reminder to think strategically about how best to prioritize your retirement savings.
Ryan Franklin is a senior financial adviser with Moss Adams Wealth Advisors LLC. A certified public accountant and a certified financial planner. You can reach him at (509) 834-2458 or ryan.franklin@mossadams.com.