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In 2012 FORBES highlighted a backdoor method for high-income folks to move money into Roth IRAs, where it can grow tax free for retirement. While couples with more than $190,000 in adjusted gross income can’t contribute to Roth IRAs directly, they can put the maximum annual IRA contribution of $5,500 a person ($6,500 for those 50 or older) into an aftertax (meaning nondeductible) IRA, which has no income restrictions, and then immediately convert it into a Roth. (Conveniently, income limits on conversions ended in 2010.)
Now there’s an even bigger-dollar Roth gambit, thanks to new, surprisingly permissive Internal Revenue Service rules governing the rollover of aftertax 401(k) contributions into Roth IRAs.
As a result, some workers may be able to funnel as much as $34,500 extra a year into Roth IRAs, while certain retirees can immediately Rothify hundreds of thousands of dollars in old aftertax 401(k) contributions without paying any conversion tax.
“For people who put aftertax dollars in their plans, it’s a huge windfall,” says New Jersey financial planner Chris Kamnitsis.
If you have traditional aftertax money in your 401(k) you can leave it in the plan where it grows tax-deferred or roll it into a Roth IRA where it grows taxfree. (Credit: Todd Pearson/Getty Images)
Retirees in the know are already springing into action. Wayne Grunewald, 62, sat on the 401(k) advisory board in his last job as corporate controller of cigarette-paper maker Schweitzer-Mauduit InternationalSWM0%. He’s rolling $180,000 of aftertax contributions from that 401(k) into a Roth IRA. “People ought to be looking at this,” urges Grunewald, who now lives in The Villages in Florida with his wife, Mary, a retired occupational therapist. Grunewald keeps busy these days as a volunteer tax preparer for the elderly and math tutor for fifth graders, as well as playing golf and pickleball and on four softball teams.
For those less familiar with arcane tax rules than Grunewald, however, this new Roth deal takes a lot of explaining.
There are three flavors of retirement account contributions: pretax, traditional aftertax and Roth. Pretax contributions cut your current income tax bill, but all withdrawals in retirement are taxed as ordinary income at a current top rate of 39.6%. Traditional aftertax contributions grow tax deferred, but withdrawals of earnings (although not of contributions) are also taxed at high ordinary income rates. Roth contributions are also made aftertax, but all withdrawals in retirement (or by heirs) are income tax free and (at least under current law) don’t raise your adjusted gross income for the purpose of various upper-income gotchas such as extra Medicare premiums (as much as $7,203 per couple this year) and the new ObamaCare 3.8% surcharge on investment income.
The virtue of Roths becomes particularly apparent when retirees turn 70 1/2 and must start taking taxable “required minimum distributions” (RMDs) from their traditional retirement accounts. Mark Lumia, the Grunewalds’ financial planner, notes that the couple, now in the 25% tax bracket, could be pushed back up into the 35% bracket when Wayne Grunewald hits 70, claims delayed Social Security benefits and then is forced to take RMDs from the more than $2.5 million he has in pretax retirement accounts.
You don’t have to take RMDs from a Roth (unless you inherited it from someone other than a spouse), but if you need extra cash–say, $40,000 for a new car or a bucket list safari–you can pull it out without bumping yourself into a higher tax bracket.
So you want Roth dollars. Now here’s how you can get more of them through a 401(k) or a similar plan for nonprofit workers.
In 2014 you can make up to $17,500 ($23,000 if you’re 50 or older) in pretax or Roth employee contributions. Yet the law actually allows more than double that–up to $52,000, or $57,500 if you’re 50-plus–to be put into a 401(k) on your behalf. This higher amount includes what your employer kicks in (always pretax), plus any extra aftertax contributions you yourself make.
Say you’re 50, earning $200,000 and making $23,000 in pretax contributions. Your skinflint employer kicks in $4,000 for a total of $27,000. Theoretically, you can top up your contributions with another $30,500 in aftertax contributions–if your plan permits it. (Unfortunately, the amount you can contribute aftertax is sometimes limited by “nondiscrimination” tests, which reduce the amount workers earning $115,000-plus can sock away if lower-paid workers don’t save.)
Before the IRS issued its new rules, making aftertax 401(k) contributions arguably wasn’t worth it. That’s because you were only deferring taxes on investment earnings, not eliminating them, and you were converting capital gains and dividends, which are taxed at a lower rate in nonretirement accounts, into highly taxed ordinary income.
The new IRS rules make aftertax contributions suddenly sexy. Here’s why: If you have $1 million sitting in traditional IRAs, with $100,000 of it from aftertax contributions and the rest from pretax contributions and tax-deferred earnings, and you want to move $100,000 to a Roth, you must convert both pretax and aftertax money on a pro rata basis, paying taxes now on the pretax part. To Rothify $100,000, you’re taxed on $90,000.
The new IRS rules, however, provide that when you’re moving money from a 401(k) to an IRA, you can separate out the aftertax contributions and roll them to a Roth IRA, without the pro rata bite. That’s true even if your employer didn’t put your pretax money in a separate account. In effect, the IRS is allowing you to roll your aftertax contributions to a Roth IRA while moving your pretax dollars and tax-deferred earnings to a pretax IRA or even to your new company’s 401(k). “You’ll need to report the transaction on your tax return, but it won’t affect the amount of tax you pay,” says Chicago tax lawyer Kaye Thomas, a Roth expert.
If your employer’s plan allows “in-service” withdrawals, you can roll aftertax 401(k) contributions directly to a Roth while you’re still working there. Yes, many plans have restrictions on how often you can do an in-service distribution. But some 401(k)s administered by the Vanguard Group, includingGoogle'sGOOGL-1.14%, allow workers to go online as often as they want and move aftertax contributions and their earnings (but, conveniently, not other money) from their 401(k)s to a Roth IRA. If you do this, put your aftertax contributions in a money market fund and go online immediately after each pay period, so you won’t have taxable gains to complicate matters, says IRA expert Ed Slott, a New York CPA.
Presto chango. Old-fashioned aftertax contributions of questionable value have become very valuable Roth dollars. Of course, to get this sweet deal, you have to be in a plan that allows the aftertax contribution top-up. Vanguard reports that 40% of the plans it administers with more than 5,000 participants and 20% of all its plans allow aftertax contributions. If your 401(k) isn’t one of them, start lobbying your boss now.