A New Rule for 401(k) After-Tax Money

The IRS recently issued a very tax-friendly ruling for anyone taking after-tax money out of their 401(k) retirement plan. If you have after-tax money in your 401(k) retirement account, you can now roll it into a Roth IRA where it will then grow tax-free (as opposed to growing tax-deferred as it would in a traditional IRA).

What’s the benefit of a Roth? The account grows tax-free, there are no taxes due on distributions, and there are no minimum required distributions. Those features combine to allow you to more effectively manage your marginal tax rate in retirement. That’s even more important given the range of capital gains rates and the 3.8% Medicare surtax on high wage earners.

This new rule provides a great way for individuals who have been prohibited from opening a Roth IRA due to their high incomes or who resisted converting a traditional IRA to a Roth IRA due to the taxes due on the conversion to open a Roth. That’s right, no taxes are due on after-tax 401(k) money moved into a Roth IRA. This amounts to a tax-free Roth conversion.

Previously if you moved after-tax money from your 401(k) to a Roth IRA, you had to pay conversion tax on any earnings associated with the after-tax money. But now you can split the rollover, moving the earnings on your after-tax contributions into a traditional IRA (where they will grow tax-deferred) and directing your after-tax contributions into a Roth IRA (where they grow tax-free.)

It used to be difficult to separate pre-tax dollars from after-tax dollars when rolling over money from an employer plan to IRAs. However, the IRS now allows us to separate those dollars and send earnings to a traditional IRA and after-tax dollars to a tax-free Roth IRA, with no up-front conversion cost.

In practice, this ruling benefits higher net-worth investors who have contributed after-tax dollars to their 401(k)s. According to Aon Hewitt, 6.6% of participants make after-tax contributions to their 401(k).

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