Many employer retirement plans now allow participants to make contributions to a Roth 401(k) plan account. These contributions are after-tax contributions, but the earnings are tax-free when distributed.
Before Roth 401(k) plan accounts were allowed, many employer plans allowed participants to make after-tax contributions to the plan and some still do.
While a distribution of the after-tax amount is not taxable, the earnings on the after-tax amounts are taxable.
Distributions are considered to include a pro rata share of both earnings on the account and the after-tax contributions.
For example, if the account balance is $100,000.00 and consists of $80,000.00 of after-tax contributions and $20,000.00 of earnings, a distribution of $50,000.00 would carry out $40,000.00 of tax free after-tax contributions and $10,000.00 of taxable earnings.
This same pro rata distribution scheme applies if a distribution from a retirement plan was rolled over to multiple IRA’s. Each rollover would be treated as having a pro rata portion of the after-tax contributions and the earnings on those contributions.
In September, the IRS issued Notice 2014-54, which is generally effective on January 1, 2015. The Notice provides that all distributions from a retirement plan made at the same time are treated as a single distribution even if they are sent to multiple destinations.
As a result of the Notice, a taxpayer can rollover after-tax contributions to a Roth IRA and rollover the earnings on the after-tax contributions to a traditional IRA. The only requirement is that the rollovers occur at the same time.
The best method to do so is to directly transfer all amounts to the two IRA’s on the same day.
The advantage of this technique is that all subsequent earnings on the after tax contributions will be forever tax free as long as the Roth IRA rules are satisfied.
For taxpayers with after-tax contributions in their employer retirement plan accounts, this change offers a significant planning opportunity that should not be overlooked when retiring or changing jobs.