IRS Permits High-earner Roth IRA Rollover Opportunity

As highly compensated employee (HCE) 401(k) plan participants approach retirement, you might draw their attention to a potentially useful tax-efficient IRA rollover technique. The IRS has specific rules about how participants can allocate accumulated 401(k) plan assets based on pretax and after-tax employee contributions between standard IRAs and Roth IRAs. (This article doesn’t address opportunities involving Roth 401(k) plans.)

High-earner Dilemma

In 2016, the top pretax contribution that participants can make to a 401(k) is $18,000 ($24,000 for those 50 and older). Plans that permit after-tax contributions (about half do) allow participants to contribute a total of $53,000 ($35,000 above the $18,000 pretax contribution limit). While some highly compensated supersavers may have significant accumulations of after-tax contributions in their 401(k) accounts, the IRS income caps block the highest paid HCEs from opening a Roth IRA.

However, under IRS rules, these participants can roll dollars representing their after-tax 401(k) contributions directly into a new Roth IRA when they retire or no longer work for the company. Thus, they’ll ultimately be able to withdraw the dollars representing the original after-tax contributions — and subsequent earnings on those dollars — tax-free.

IRS Guidance

Participants can contribute rollover dollars to conventional and Roth IRAs on a pro-rata basis. For example, suppose a retiring participant had $1 million in his 401(k) plan account, $600,000 of which represents contributions. Suppose further that 70% of that $600,000 represents pretax contributions, and 30% is from after-tax contributions. IRS guidance clarifies that the participant can roll $700,000 (70%) into a conventional IRA, and $300,000 (30%) into a Roth IRA. Although the portion of the $300,000 rolled into the Roth that represents earnings on those after-tax contributions (40% of the $300,000, or $120,000) will be taxable for the year of the rollover, subsequent growth on the Roth will be tax-free when withdrawn.

The IRS rules allow the retiree to delay taxation on the earnings attributable to the after-tax contributions ($120,000) until the money is distributed by contributing that amount to a conventional IRA, and the remaining $180,000 to the Roth. Partial rollovers can also be made, and the same principles apply.

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