Strategies arise to take advantage of new IRS after-tax rollover

Though after-tax dollars in a 401(k) can now be rolled into a Roth IRA, few employers accept such contributions

Sep 24, 2014 @ 12:01 am

By Darla Mercado

Advisers are weighing strategies in light of the IRS' recent announcement on its treatment of after-tax money in 401(k) plans, but those opportunities might be hard to come by at the employer level.

Last week, the Internal Revenue Service released guidance in Notice 2014-54, indicating it would allow savers to break out the after-tax portion of money they've contributed to a retirement plan and convert it to a Roth IRA free of taxes. That announcement will affect distributions made on or after Jan. 1, 2015.

The announcement settled a long-running discussion in the tax community about the best way to address contributions in excess of the maximum allowed. Would the IRS deem Roth IRA rollovers of that money acceptable?

“There was a mixed feeling in the planning community,” said Tim Steffen, director of financial planning at Robert W. Baird & Co. “There was a perception that they probably could do it, and some advisers said you could do it. But most people felt that it was probably not going to fly.”

Currently, the amount employees can put into their 401(k) is $17,500, and the total amount of all contributions to defined contribution plans is $52,000.

Advisers looking to make a move for a high-earning client might consider a strategy that Jim McGowan, an adviser at Marshall Financial Group, calls the “mega backdoor Roth contribution.”

“You put after-tax money into the 401(k), then you do a rollover of the cost basis of the after-tax portion when you separate from service,” he said.

In other words, add after-tax dollars to a 401(k), then roll over the after-tax contributions upon leaving the employer.

Another option: Take advantage of plans that permit in-service distributions rather than waiting until retirement or changing jobs. Move that after-tax money to a Roth IRA using an in-service distribution, said Mr. McGowan.

But there is a massive obstacle that's standing between those high-earning clients and the potential tax savings: the availability of a workplace program that permits them to save after-tax dollars in the plan.

Retirement plan advisers have said after-tax savings programs aren't a common feature at the employers they're working with. In fact, some companies have actively backed away from those programs.

“We had a handful of clients over the years who had this feature and many stopped talking about it because it's an administrative headache and they didn't want to deal with it,” said Michael Francis, president of Francis Investment Counsel, a firm that works with retirement plans.

For one thing, employers worry about rank-and-file employees viewing them as doling out additional benefits to the highest earners. A dramatic amendment to the retirement plan, especially one that would allow after-tax contributions back to the plan, would warrant an educational campaign and an announcement to all of the employees, Mr. Francis observed.

For plan sponsors, the issue goes back to whether they're able to keep the contributions in the 401(k) separate from the earnings, as the earnings on that after-tax money can't be pulled into the Roth free of taxes — only the after-tax money, noted Dave Richmond, president of Richmond Brothers, a registered investment adviser. Though larger employers are likely to already have their custodians account for contributions separately from the earnings, this isn't necessarily the case for smaller firms.

“You find a lot of inconsistency [among smaller companies]: Some did it and some didn't do it,” Mr. Richmond said. “Now that the IRS says you can [roll over after-tax dollars], from now on they have to keep it separate going forward.”

Still, there are potential benefits for at least raising the issue to small business clients.

For instance, making the necessary adjustments to the plan documents could be viewed as a way to help middle management employees add more to the retirement plan to ensure the plan isn't entirely skewed to the top executives who already max their savings via deferred compensation plans.

“There are a lot of people who aren't the upper echelon executives, and who might be middle management, and this is good for them,” Mr. Richmond said.

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