After-tax 401K to Roth IRA

Have you ever wondered how to save more (beyond $18K IRS limits) and also convert to Roth IRA? And how about having flexibility of using those funds for big-expenses like kids college? Well – thanks to recent tax-law changes, there may be an answer. However as always, it’s hidden in complex US tax code. Thanks to some excellent research by my colleagues Anand and Venkaiah, here is simplified version.

All of us know what 401K means and how it works. The standard limit on 401K contributions is $18K per year ($24K if you are 50 or older). However you can still contribute after-tax money to 401K. Limit for total contributions from all sources and to all retirement accounts is $53K per year ($59K per year if you are 50 or older). This includes 401k, ROTH 401K, after tax 401K and any employer matching contributions.

e.g. For an individual under 50, let’s assume following:

• ·      Employee contributes $18K per year
• ·      Let’s say at 5% employer match, employer contributes $10K per year (would depend on many factors so use this just as illustration)
• ·      That means, one could still contribute 53K – 18K – 10K = $25K in after-tax 401K
• ·      As a side note, if you contribute to after-tax ROTH 401K, it would be counted towards $18K limit

Now how to optimally utilize these after-tax 401K contributions?

Note that these are after-tax contributions means they are NOT tax deductible but any gains are tax-deferred. Also these contributions normally must happen from your regular pay-check means your company needs to have these in their 401K plans. Depending on the plans, you can convert these after-tax contributions to Roth IRA in following ways:

• When you leave company or retire or
• In-plan conversions (depending on your company plans)

When you convert, to make this a non-taxable event, you can opt for after-tax contributions to go to a ROTH IRA and any associated gains to go to a traditional IRA

Let’s continue the example we took:

• ·      Let’s say you are making after tax contributions of $20K per year for 5 years totaling $100K in after-tax contributions
• ·      Over 5 years this account had gains of say $40K
• ·      At end of 5 years you decided to convert this. Here is how it could be converted
• o   $100K would go to Roth IRA
• o   $40K would go to Traditional IRA

Traditional IRA withdrawals in retirement are taxed at ordinary income tax rates. Roth IRAs earnings and withdrawals are generally tax-free.

Depending on your situation, you can decide when to convert after-tax contributions but in general early the better if plan allows. Contributions in Roth IRA, can be withdrawn penalty free after 5 years and one could even withdraw the associated gains penalty free for some expenses (including college expenses) after 5 years.

Hope you got some useful information to think about. 

For more information, here are some references:

http://www.nytimes.com/2015/09/23/your-money/401ks-and-similar-plans/irs-ruling-makes-after-tax-contributions-more-attractive.html

https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans

http://news.morningstar.com/articlenet/article.aspx?id=682209

http://www.doughroller.net/retirement-planning/pros-and-cons-of-after-tax-401k-contributions

Disclaimer: This blog is only for information purpose only. Before you take any specific actions, please do your own due-diligence including discussing with your advisor.

/Shyam