Blog - IRS Clears the Way for After-Tax 401(k) Rollover to Roth

Internal Revenue Service (IRS) Notice 2014-54 has cleared the way allowing direct rollover of after-tax contributions in a 401(k), 403(b), or a § 457(b) plan maintained by a governmental employer to be rolled directly into a Roth IRA. Before we get into the details, here’s a little background on the Roth IRA.

For tax year 2014, if a single taxpayer’s adjusted gross income (AGI) is over $114,000 or married filing jointly taxpayers’ AGI is over $181,000, they begin to be phased out of making Roth IRA contributions. When eligible for the full annual Roth IRA contribution, each taxpayer can contribute $5,500 (plus $1,000 extra if over age 50) to a Roth IRA. Why is the Roth IRA so important? While contributions are made with after-tax dollars and you receive no tax-deduction, qualified Roth IRA distributions are tax-free. That means you pay no taxes on the growth!

In the past, the IRS has said if you make after-tax contributions to a 401(k) and you rollover the monies, all must go to a IRA or distributions are considered to be split pro rata, essentially removing the option to breakout the after-tax contributions from the pre-taxed contributions without paying taxes.  It appears that so many taxpayers have complained about this and tried to find ways around it that the IRS has acquiesced and changed the rule.

As long as your employer’s 401(k) plan allows for it, you can max out the pre-tax contributions for the 401(k) ($17,500) and then make additional after-tax contributions as long as the total of all employee and employer contributions for 2014 do not exceed $52,000. Any after-tax 401(k) contributions would be eligible for a direct rollover upon separation of service to a Roth IRA with no tax consequences.  Beware of a “gotcha:” The rollover to the Roth has to be made at the same time as the pre-tax contributions are rolled to avoid having them treated as two separate rollovers thus triggering the pro-rata rollover rules. You also have to ensure that the growth on the post-tax contributions are not rolled to the Roth and stay with the pre-tax monies during the rollover process to avoid having to deal with conversions.

This new rule is great news and now opens up another avenue for high income earners to utilize a Roth IRA.


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