Huge Increase in Roth Contribution Trick
I know the non-deduct IRA part is accurate, but I want to double check if the 401k part is accurate?
“Trick 7: Contribute to Roth if above income level
Maybe you make too much to deduct your traditional IRA contribution and you make too much to contribute to a Roth at all. Remember you can still contribute $5K to your traditional IRA, there’s just no tax deduction and you get a basis equal to your contribution. Do this anyway, even thought the tax benefits are marginal, since next year even rich people can convert from traditional to Roth IRAs. You’ll pay taxes on your earnings (but not your basis), so if all you had was a $5K non-deductible IRA, you’d only pay taxes at conversion equal to the earnings since you invested (if any). Next year you’ve got a $5K Roth.
Similar situation, but instead you have a 401k plan that allows after-tax contributions. These are beyond the (currently $16500) elective deferral limit, and are capped together with any employer matches, employer contributions, and elective deferrals at $49K. Since elective deferrals are almost always better, this still leaves you the option to contribute $32500 in after-tax contributions. These are treated very similarly to a non-deductible traditional IRA. Pending your company’s 401k plan rules, you can then roll out the after-tax portion only (which has basis equal to your after-tax contribution amount) and then do the traditional to Roth conversion next year and pay taxes only on any earnings in the meanwhile. Who doesn’t want a $30K boost to their Roth limit?
Net Effect: ability to contribute to a Roth IRA when you make more than the $120K(single)/$176K(MFJ) limit on AGI, and the ability to effectively contribute much more to a Roth account via the 401k than the normal $5K limit. For the non-deductible IRA, this is available to everyone. For the after-tax 401k, most 401k plans don’t offer the after-tax option but it can’t hurt to check.
Comments: Be aware that when you convert traditional IRAs to Roth’s, if you have other traditional IRAs with lower basis there can be complications. You must treat a conversion as being made proportionally from all traditional IRAs, so the conversion may incur tax since you are effectively being forced to convert some portion of the prior pre-tax amounts as well as the non-deductible amount. For the 401k option, be aware the most HR people have never heard of after-tax contributions, so expect some blank stares. Also, make sure you check the 401k plan documents for if they will allow after-tax money to be rolled out while continuing employment. It’s allowed by the IRS (unlike the very strict rules on elective deferral rollouts), but your plan may choose not to allow this.”
Permalink Submitted by Alan Spross on Fri, 2009-12-04 02:15
The main problem is that 401k plans are only allowed to distribute pre 1987 after tax contributions separately, providing they account for them separately. If they do, that fixed value will usually show on the employee’s statement. All other after tax contribution can only be distributed pro rata with the pre tax amounts, similar to how IRA distributions are pro rated. In addition, non hardship in service distributions for most plans is very limited, at least until age 59.5 occurs. In total using after tax contributions in 401k plans will probably be met with very limited opportunities. One such limited opportunity may be the recharacterization of certain pre tax contributions exceeding code limits as after tax contributions rather than taking taxable distributions.
Another opportunity is the increasing number of plans that allow Roth contributions as well as pre tax contributions to the plan. There are no income limits for making these contributions, but the after tax paycheck will diminish because the elected Roth portion is after tax. Roth 401k accounts also carry some different distribution tax rules than Roth IRAs, including RMDs if left in the plan at the RBD. Most plans allow periodic changes to the pre tax vrs Roth deferral percentages. There are NO allowed conversions of pre tax amounts to the Roth option within these plans. If there are pre tax amounts in these plans that are to be converted, they must be converted to a Roth IRA when distributions are permitted.
Since many employees now meet the age requirements for catch up contributions in both IRA and qualified plans, these extra amounts should be identified in this release since they do increase deferral amounts by a considerable portion for those that have reached age 50 in the calendar year.
Permalink Submitted by mk foss on Fri, 2009-12-04 03:10
I may be having trouble following this. The terminology at the top is confusing because you cannot contribute to a Roth IRA if you’re over the income limit. Instead you do what you’ve described – contribute to a nondeductible IRA then convert to Roth.
Although there is no income limit for contributions to a Deferred Roth Account within a 401(k) plan – the elective deferral limit ($16,500) is split between Roth and traditional 401(k) pre-tax deferrals. No employer match or forfeitures can be added to the Roth 401(k) – I’m not following the numbers in the “trick” based on this.
I agree with Alan that it would be difficult to distribute the Roth 401(k) separately from the other components of the qualified plan even though the custodian is required to keep track of the basis in the Roth 401(k).
Permalink Submitted by Jon Dennison on Fri, 2009-12-04 21:18
[quote]All other after tax contribution can only be distributed pro rata with the pre tax amounts, similar to how IRA distributions are pro rated.[/quote]
I’m curious in reading the part of the tax code for this.
So you the trick I quoted was wrong in saying that an employer will not have different in service withdrawal rules for non-deductible(taxable at distribution) contributions than the elective deferrals?
[quote]One such limited opportunity may be the recharacterization of certain pre tax contributions exceeding code limits as after tax contributions rather than taking taxable distributions.[/quote]
Can you explain this further?
Key questions:
You do agree that a person can contribute to a 401k on a non-deductible basis in excess of there 16500 deferral limit if there plan provider allows this?
You do agree that money is treated as being part of a qualified plan and can be rolled over to a Roth IRA with only taxes on the earnings?
But your also saying that a person might have trouble getting that money out while still employed at the company?
I’ve met people that have access to in-service withdrawals in there plan, are they really that rare(and I’m not saying hardship withdrawals)?
mgtf4cpa,
Your first part is right. We aren’t talking about a Roth 401k account in your second paragraph. We are talking about non-deductible(taxable at distribution) contributions into your 401k. These can be done in excess of deferral limits, not many plans offer them, and not many people no about them. If these were never rolled, they probably wouldn’t be very efficient unless you held tax inefficient investments inside of it. The only the real value would be to take that account and roll it is often as you can.
For your last paragraph, we aren’t talking about Roth contributions we are talking about after tax non-deductible(taxable at distribution) contributions in excess of deferral limits.
Permalink Submitted by Alan Spross on Fri, 2009-12-04 23:12
Copy of Sec 72(b)8 relating to taxation of non annuity distributions from a qualified plan. The final paragraph addresses the pre 87 after tax contributions which escape the pro rata treatment:
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72b(8) Extension of paragraph (2)(b)1 to qualified plans
(A) In general
Notwithstanding any other provision of this subsection, in the case of any amount received before the annuity starting date from a trust or contract described in paragraph (5)(D), paragraph (2)(B) shall apply to such amounts.
(B) Allocation of amount received
For purposes of paragraph (2)(B), the amount allocated to the investment in the contract shall be the portion of the amount described in subparagraph (A) which bears the same ratio to such amount as the investment in the contract bears to the account balance. The determination under the preceding sentence shall be made as of the time of the distribution or at such other time as the Secretary may prescribe.
(C) Treatment of forfeitable rights
If an employee does not have a nonforfeitable right to any amount under any trust or contract to which subparagraph (A) applies, such amount shall not be treated as part of the account balance.
(D) Investment in the contract before 1987
In the case of a plan which on May 5, 1986, permitted withdrawal of any employee contributions before separation from service, subparagraph (A) shall apply only to the extent that amounts received before the annuity starting date (when increased by amounts previously received under the contract after December 31, 1986) exceed the investment in the contract as of December 31, 1986.
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Some plans offer recharacterization to after tax contributions of pre tax contributions that are disallowed by discrimination testing, ie high salary employees contributed too much of the total plan contributions. Instead of taking these funds out as taxable, they can be recharacterized as after tax contributions. This is up to the plan. Some plans may also offer different types of in service distributions relative to various types of contributions. But my take is that the plan that will only allow after tax contributions to be distributed while in service will be very few and far between, that is other than the pre 87 amounts discussed previously.
So, while this strategy could work in theory, I think it will be very difficult to find a plan that will allow post 86 after tax contributions to be distributed without pre tax contributions on a pro rated basis. I understand that you were only considering non Roth after tax contributions, not designated Roth contributions.
Key questions:
1) Yes, if the plan allows it
2) This would have to be a special provision, and I believe them to be extremely rare. Most in service distributions allowed would include the appropriate amount of pre tax contribution along with any after tax contributions. Earnings on after tax contributions are added to the pot of pre tax contributions.
3) Yes, until the plan age is reached. That is age 59.5 in most cases other than hardship distributions and hardships cannot be rolled over. Occasionally, you might run into a plan that allows these at a lower age. Those might include industries where employees physically don’t usually last into their 60s, eg firefighters or very strenuous industrial jobs where unions have negotiated a lower normal retirement age for the DB pension plan as well.
Permalink Submitted by Jon Dennison on Fri, 2009-12-04 23:37
Can Roth 401k contributions be re characterized, to traditional deductible 401K contributions? If so, I believe this would be really useful in the event of market losses.
2) I meant if the person terminated employment for example(question 3 dealt with while employed).
3) Sales jobs where the employer really wants to keep them happy.
Lets say people couldn’t do in service withdrawals. We could start running models on an age when it becomes beneficial to start using the non-deductible contributions for the purpose of rolling at 59 and 1/2. If I were to guess an age to start it would be around 52 depending on when distributions were expected to start(what do you think).
Also we could design a model for those that believe they will be switching jobs, etc. in the future.
Permalink Submitted by Alan Spross on Sat, 2009-12-05 00:00
1) No, currently there are no recharacterization or conversions between designated Roth accounts and the pre tax account. However, I think there is a proposal in Congress to liberalize the designated Roth rules to make them more similar to Roth IRAs. No idea if it will have any traction.
2) At separation, all these plans MUST offer distributions and provide a 402f notice outlining the ex employee’s rollover options.
3) More and more 401k plans are offering the Roth option where there are no income limits for contributions. Those contributions would always be more beneficial than after tax contributions to the pre tax account because earnings would be tax free eventually. However, the employer match cannot be done into the Roth account. If there is no Roth option, then after tax contributions would be handled about the same manner as a non deductible IRA contribution. There would be no deduction, and distributions could come out pro rated with pre tax amounts and earnings from all sources. There is currently a very restrictive way to transfer the pre tax amount to a TIRA and the after tax contributions to a Roth IRA, but it involves doing an actual distribution, not a direct rollover. Employees then have to deal with 20% mandatory withholding on the pre tax amount by fronting that money until they get a tax refund. Then they first roll over the grossed up pre tax amount to a TIRA, and lastly the after tax amount to a Roth IRA. Rules that allow this require the employee to receive the funds first, rather than just doing direct rollovers. Hopefully, the IRS will release a notice making this easier sometime soon. For various reasons, employees have more after tax amounts in these qualified plans that most people would expect, and the most tax efficient strategy would be to convert them to a Roth directly as soon as they are eligible for distributions. In most cases though, this would be after separation, in some other cases after 59.5 while still active, and perhaps in a very few cases prior to 59.5 while still active.