High-income earners have a new incentive to make after-tax
contributions to a 401(k) plan: They can later shift those contributions into a
Roth individual retirement account, tax-free. Thanks to a recent Internal
Revenue Service ruling, eligible employees can now move after-tax contributions
directly from their employer-sponsored retirement plan to a Roth account.
The potential tax savings are huge, depending on an
investor’s tax rate in retirement. Money in a Roth IRA grows tax-free and isn’t
taxed when it is withdrawn, and Roth IRA withdrawals don’t raise an investor’s
adjusted gross income. That, in turn, can help lower Medicare premiums or the
3.8% surtax on net investment income.
The IRS’s decision helps high-income people funnel
potentially significant amounts of money directly into a Roth. Normally,
couples with adjusted gross incomes of $191,000 or more and individuals with
incomes of $129,000 or more can’t directly contribute to a Roth IRA.
Most contributions to a company-sponsored plan are made with
pretax money. That reduces a worker’s current tax bill, but withdrawals in retirement
are taxed as ordinary income, at rates up to 39.6%. Such withdrawals could push
an IRA owner into a higher tax bracket.
Once a retiree hits age 70½, when required minimum
distributions from retirement savings kick in, the advantages of Roth IRAs
become even more clear. Roths don’t have required minimum distributions, while
other savings do, and Roth withdrawals don’t run the risk of pushing a person
into a higher tax bracket because they don’t count as income.
The new rules—which also apply to nonprofit-sponsored 403(b)
plans—are supposed to go into effect next year, but the IRS said in September
that investors could start making the transfers now. The IRS’s announcement
means that savers no longer have to follow complicated strategies to reduce
their tax hit when moving money from a company plan to a Roth IRA. It also
means that people whose incomes are too high for them to fund a Roth IRA now
have a way to do just that.
Such transfers have to be made at the same time savers roll
their existing 401(k) pretax savings into a traditional IRA. Savers who want to
take advantage of the new rule must first contribute the maximum pretax amount
to their 401(k) or similar plan. In addition, the plan must allow contributions
of after-tax funds.
Even now, after-tax contributions—if allowed by the
plan—could make sense for people who have extra cash they won’t need until they
are 59½ or those who have unique or low-cost investment options in their
company plans, experts say.
The latest decision gives people an easier way to
distinguish pre- and after-tax contributions and maximize their potential tax
savings. That could make it much easier for investors to move tens or hundreds
of thousands of dollars they have had accumulating in their 401(k)s into a Roth
IRA.
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