New Path to a Tax-Free Roth Conversion

Can after-tax money in a traditional 401(k) be moved directly to a Roth IRA tax free? For years, IRS guidance left the answer murky, causing financial advisers to offer conflicting advice.

Now the IRS has finally cleared things up: Taxpayers can now split after-tax money from a traditional 401(k) and send it directly to a Roth. The ruling makes life easier for retirees, while also helping them boost tax-free savings. "It's a sweet deal," says Mike Piershale, president of Piershale Financial Group, in Crystal Lake, Ill.

Beware, though, that few company plans accept after-tax contributions in a traditional 401(k). Each company plan sets its own rules and doesn't have to offer all the features the IRS blesses. In his experience, Ryan Sullivan, a financial planner in the Traverse City, Mich., office of Rehmann Financial, estimates that about 10% of the thousand plans his company works with allow after-tax contributions. But with this new rule, he says, that number could grow.

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Ask your plan's administrator to spell out the features your plan offers. "The stars have to align," says Jeffrey Levine, IRA technical consultant for Ed Slott and Co., which provides IRA advice. If they do, he says, this is a "powerful strategy."

Say you have a traditional 401(k) worth $100,000, holding $80,000 of pretax money and $20,000 of after-tax money. Perhaps you're retiring and you want to roll the money out of the plan. The IRS will now let you transfer the pretax $80,000 directly to a traditional IRA and the after-tax $20,000 to a Roth IRA. The cost of this move: zero.

While it has been easy to roll Roth 401(k) money to a Roth IRA tax free, that hasn't been the case with after-tax money in a traditional 401(k). Before the IRS ruling, you could roll the money into a traditional IRA and a Roth IRA, but you would get hit with a tax bill because pro rata rules would apply. You would owe income tax on the money going to the Roth based on the ratio of pretax money to the total 401(k) assets -- in this case, 80% of the total.

If you moved $20,000 to a Roth, only 20% of it would be considered after-tax money and therefore tax free; the rest would be considered pretax money. So $16,000 would be taxed, triggering a $2,400 bill in the 15% bracket. Money could be converted from the traditional IRA holding the $80,000, but only a portion of each conversion would be tax free because under the old rules just part of the traditional IRA would be made up of after-tax money. Under the new ruling, "you can experience a Roth conversion without having to pay taxes for a Roth conversion," says Sullivan.

But even with the new rule, you "can't just pull out the after-tax money," says Levine. Say you want to take $50,000 from the $100,000 401(k). Only 20% -- or $10,000 -- would be considered after-tax money and could go directly to a Roth IRA tax free.

Boost Tax-Free Savings

High earners who want to turbocharge tax-advantaged savings should take note of the new IRS rule. "It's a great planning opportunity for people who can't contribute to a Roth IRA," says Sullivan, if their plan allows it. For 2014, the ability to contribute to a Roth IRA phases out for single filers at $129,000 of modified adjusted gross income and for joint filers at $191,000.

There are no income limits on converting a traditional IRA to a Roth IRA, but generally conversions come with a tax bill. And while high earners can make nondeductible contributions to a traditional IRA and then convert that money to a Roth, traditional IRA contributions are limited to $5,500 a year for 2014 (plus an extra $1,000 if 50 and older).

Instead, you could load up your 401(k) with after-tax contributions. Pretax contributions are capped at $17,500 for 2014 (plus an extra $5,500 if 50 and older), but the total contribution limit is $52,000 for 2014, or 100% of compensation, whichever is less. That overall limit includes all employee and employer contributions.

The after-tax money will grow tax-deferred in the 401(k). At distribution time, that after-tax money can be split off into a Roth IRA to grow tax-free while earnings and pretax contributions go to a traditional IRA. "If you're looking for more places to save money, this is a great place to do it," says Sullivan.