While the 2016 defined contribution plan limits for 401(k) plans remain unchanged as compared to 2015, participants should now give extra consideration to making additional after-tax contributions (if allowed by the plan) due to recent changes in tax regulations. Under IRS Notice 2014-54, the IRS has agreed that a plan participant can now directly roll over pre-tax account balances into a Traditional IRA account, and after-tax account balances into a Roth IRA account.
What this means is that a 401(k) plan participant can first maximize out either a Traditional 401(k) or Roth 401(k) contribution up to the plan limit of $18,000 ($24,000 if age 50 or older). If the plan allows, a participant can also elect to make additional after-tax contributions into the plan. The after-tax contributions are not tax deductible in the year contributed, but any future income or capital appreciation accumulates on a tax deferred basis. Most importantly, upon retirement or termination of employment, the participant is allowed to directly roll over the cumulative total of after-tax contributions into a Roth IRA. Since no tax deduction was received when these contributions were made, the rollover is completely free of any income taxation. The Roth IRA can then grow free of income taxes, and future qualified distributions from the Roth IRA will be income tax free.
As an example, assume that a participant made an after-tax contribution of $5,000 (in addition to making the maximum Traditional or Roth 401(k) contribution) each year for a period of 20 years. At retirement, the 401(k) account would be split into multiple pieces consisting of pre-tax, Roth 401(k) and cumulative after-tax components. The cumulative after-tax contributions of $100,000 ($5,000 per year x 20 years) would be directly rolled over into a Roth IRA. The Roth 401(k) component could also be rolled into a Roth IRA while the pre-tax component would be rolled into a Traditional IRA.
Where would this savings strategy fit into a typical prioritized tax-efficient retirement savings hierarchy?
• Obtain 401(k) match;
• Contribute further to max out pre-tax IRA and 401(k); or Roth IRA and Roth 401(k) if more appropriate based on analysis of current versus future tax rates;
• Make after-tax contributions to the 401(k) plan if permitted, up to the annual defined contribution plan limits, in anticipation of rolling those after-tax contributions to a Roth IRA in the future;
• Additional savings into other after-tax accounts.
Please be sure to contact us if you have any questions about how this strategy may fit into your retirement planning.
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