Turn Tax-Deferred Money into Tax-Free Money at No Cost
Anyone with earned income can contribute after-tax money to a Traditional IRA, even if you are covered by a workplace plan, and regardless of your total income.
After-tax contributions to your Traditional IRA can be converted to a Tax-free IRA.
Moving money from an IRA to a 401(k) is unconventional, but sometimes a smart move.
For after-tax contributions to a workplace retirement plan, (e.g. 401(k)), the plan administrator will keep track of pre-tax and after-tax amounts. If after-tax contributions are made to your Traditional IRA, then it is your responsibility to track the amounts.
First, let’s review how these after-tax contributions work. The contributions are made with income on which you have already paid taxes, and therefore the contributions are not taxed when distributed back to you. However, investment earnings on these after-tax contributions are not tax-free, only tax-deferred. This is different than earnings from Roth 401(k)s and Roth IRAs, where contributions and any investment earnings are distributed tax-free if your account has been open for at least five years.
The most cost-effective strategy is to convert those after-tax contributions in your workplace retirement plan to a Roth IRA as soon as possible, thus achieving more years of tax-free growth vs. tax-deferred growth. How can this be accomplished?
Let’s say your 401(k) balance holds $200,000 of pretax amounts and $50,000 of after-tax amounts. If you leave your job, you can rollover the full $250,000 into two separate IRAs. The $50,000 can be rolled into a Roth IRA because those contributions have already been taxed. The $200,000 of pre-tax dollars would be rolled into a traditional IRA because they are subject to taxation upon disbursement. Simple, right?
Using the same example above, what if you only want to rollover a portion of your 401(k), say $100,000? In that case, you cannot choose to put all $50,000 of after-tax money into a Roth IRA. You must use the pro-rata rule, where the pretax amount is $80,000 (four-fifths) and the after-tax amount is $20,000 (one-fifth). Only $20,000 can be rolled into the Roth IRA, and $80,000 gets rolled into a Traditional IRA.
Even if you are not leaving your job, your retirement plan administrator may allow “in-service” distributions, which would allow you to employ the above strategy while you are still employed.
Now let’s discuss how to best deal with the more difficult conversion strategy where you have both pre-tax and after-tax money in a Traditional IRA. If you convert part of it to a Roth IRA, you must use the same pro-rata rule described above. This can get cumbersome if your strategy is to make Roth conversions on a yearly or regular basis.
For example, let’s say you have a Traditional IRA with $95,000 of pre-tax money, and this year you added a $5,000 after-tax contribution because your income did not allow any other way to contribute to your IRA. If you try to convert that $5,000 to a Roth IRA (often called a backdoor Roth) you encounter the pro-rata rule. According to the IRS, if you convert $5,000 from the Traditional IRA, only $250 (i.e. 5/100) would actually be converted to a Roth. The other $95,000 would be an immediate taxable distribution to you.
The good news is there could be a clean way to separate after-tax from pre-tax money in your Traditional IRA. I will discuss this strategy with you next week in part four of this four-part series.
As you can see, navigating the rules of retirement plans can get tricky. Without a defined benefit retirement plan from an employer who took all the responsibility for providing you with retirement income, the onus is now on the individual to create that future income. Consult with your financial advisor to put you on the best path possible.