How After-Tax Contributions Become Tax-Free Retirement Income

For many years, after-tax contributions to retirement plans were like the seventh batter on a professional baseball team. Weaker tax incentives meant after-tax contributions didn’t offer the same performance potential as before-tax or Roth contributions, but they still were good enough to earn a place in the lineup.

IRS ruling changes the game

That changed in late-2014, when a ruling[1] from the Internal Revenue Service (IRS) bumped after-tax contributions up in the batting order. The new rules gave participants the option to:

1. Rollover after-tax contributions into Roth IRAs when participants retire or leave their companies; or
2. Convert after-tax contributions to Roth plan contributions in-plan, as long as plan documents allow it.

Since limits on after-tax contributions are far more generous than those on pre-tax or Roth contributions, or Roth IRAs, these changes give serious savers opportunities to build sizeable Roth accounts.

Roth IRA contribution limits

The trouble with Roth IRAs, which offer a great way to save for retirement, is that there are contribution and income limits. For 2016, the maximum annual contribution to a Roth IRA is $5,500 ($6,500 for people who are age 50 or older). However, many Americans cannot contribute to a Roth IRA. For example,[2]

• A person who files taxes as a single and earns $132,000 or more each year cannot save in a Roth IRA.
• A couple that files taxes jointly and earns $194,000 or more each year cannot save in a Roth IRA.

There is a way for everyone—regardless of income level—to save more in Roth advantaged accounts. It involves making after-tax contributions to employer-sponsored retirement plans.

Roth opportunities through employer-sponsored retirement plans

If a 401(k), 403(b), or 457(b) plan allows it, employees can make Roth contributions and after-tax contributions to their plan accounts. Generally, there are no income limits on plan contributions. However, there are contribution limits.

Traditional and Roth 401(k) plan contributions together cannot exceed $18,000 in 2016 ($24,000 for savers who are age 50 or older).[3] Despite this limit, plan participants can still accumulate significant tax-free savings for retirement.

For instance, imagine a fictional participant named Donna contributes the maximum to a Roth plan account from age 40 to age 67. She makes catch-up contributions beginning at age 50, and earns 5% on average, each year. At retirement, Donna will have about $1.3 million in Roth savings to generate income. If she applies the 4% Rule, she can withdraw about $52,000 each year, tax-free.[4]^,[5]

It should be noted that any tax-deferred earnings must rollover into a Traditional IRA or they may be taxed as ordinary income. When distributions are taken from a Traditional IRA, generally, they are taxed as ordinary income.[6]

In-plan Roth conversions allow rollover of earnings

Another beneficial option would be for Donna to contribute the maximum to both her Roth and after-tax plan accounts and complete an in-plan conversion each year. An in-plan Roth rollover may include elective deferrals, matching contributions (including qualified matching contributions), non-elective contributions (including qualified non-elective contributions), rollover contributions, after-tax employee contributions, and earnings on the above contributions.[7]

Of course, a plan’s documents must allow Roth contributions, after-tax contributions, and in-plan conversions for highly compensated participants to adopt this strategy.[8]

Summary

The 2014 IRS ruling clarifying the rollover of after-tax contributions into Roth accounts gives serious savers the opportunity to significantly increase the amount of tax-free assets they can accumulate, as well as the amount of tax-free retirement income they have the potential to generate throughout retirement. Plan participants should work with their tax or financial advisors to determine if it’s a strategy that’s right for them.

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[1] Internal Revenue Service. “Guidance on Allocation of After Tax Amounts to Rollovers.” Notice 2014-54. www.irs.gov cited May 2016.

[2] Internal Revenue Service [https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-for-2016] [3] Internal Revenue Service [https://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts] [4] William P. Bengen. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning. October 1994. [http://www.retailinvestor.org/pdf/Bengen1.pdf ] [5] The 4% Rule assumes that it’s safe to withdraw 4% of savings each year during retirement if the savings needs to last for 30 years. There is some debate about whether 4% is a safe withdrawal rate over 30 years of retirement. Some experts suggest retirees should take a smaller percentage of savings each year.

[6] Internal Revenue Service, “Rollovers of After-Tax Contributions in Retirement Plans.” www.irs.gov cited May 2016. [https://www.irs.gov/Retirement-Plans/Rollovers-of-After-Tax-Contributions-in-Retirement-Plans] [7] Internal Revenue Service, “Retirement Plans FAQs on Designated Roth Accounts,” www.irs.gov cited May 2016. [https://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts#irr] [8] Ibid.