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When Roth IRAs were introduced back in 1997, they revolutionized the way people save for retirement. Before, tax-deferred accounts like 401(k)s and traditional IRAs were designed primarily to shelter income from current taxation, with the trade-off that retirees would have to pay taxes on their withdrawals during retirement. The Roth, however, offers truly tax-free investment, with no taxes even on retiree withdrawals. That has made Roths popular, but income limits have limited some high-income taxpayers from using Roth IRAs. But with help from a recent ruling from the IRS, many retirement savers are going to find it a lot easier to use a Roth as part of their retirement planning.
Getting around Roth limits
Under current law, those who earn too much aren't allowed to make contributions directly to a Roth IRA. For single filers, having income of $129,000 or more makes you ineligible, and joint filers face a $191,000 income limit to contribute to a Roth.
But if you participate in an employer-sponsored retirement plan that allows you to make after-tax contributions, then there's a backdoor you can use to get into a Roth IRA. If you roll over your retirement plan assets, you can choose a Roth IRA as the destination for the rollover, and no income limits apply.
The problem with that strategy in the past has been that most people had a combination of pre-tax and after-tax contributions in their 401(k) accounts. There was no good way to separate out the pre-tax and after-tax portions into different types of rollover IRAs, and they had to pick whether they'd prefer a Roth IRA or a traditional IRA as the target for rolling over their plan assets.
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As a result, savers faced two unappealing choices with the rollover strategy. If they chose a traditional IRA as the rollover target, then they wouldn't get tax-free treatment on the earnings from the after-tax portion of their assets -- effectively increasing their tax bill during retirement without any corresponding benefit. On the other hand, if they rolled over their retirement plan assets into a Roth IRA, they had to pay taxes immediately on the part of the account that represented pre-tax contributions. Either way, the results fell short of the best possible outcome.
Doing the IRS split
The IRS ruling last month on retirement rollovers makes things a lot simpler and more understandable for those using this strategy to get money into a Roth IRA. According to the new rules, you're now allowed to separate out your pre-tax contributions from your after-tax contributions and send them to different types of IRAs simultaneously. That makes it possible for you to open a Roth IRA for the after-tax portion of your retirement plan at the same time that you open a traditional IRA to receive your pre-tax retirement assets. Therefore, you eliminate the waste of not getting tax-free treatment on your after-tax contributions, and you avoid paying taxes on pre-tax money that would otherwise have ended up in your rollover Roth IRA.
Source: Flickr user _e.t.
One thing to remember, though, is that the IRS ruling falls short of the perfect solution for retirement savers. Ideally, what many savers would want to do is to roll over just part of their existing 401(k)s, getting after-tax contributions into a Roth IRA as soon as possible but preserving their pre-tax money in the 401(k). That's not allowed under the notice, as you're required to separate out whatever dollar amount you roll over in proportion to the percentage of pre-tax and after-tax contributions in the account.
In addition, don't get confused between after-tax contributions to a regular 401(k) and contributions to a Roth 401(k). If your employer offers a Roth 401(k) option, then that will always be a better choice than a regular after-tax contribution, because any earnings from your Roth 401(k) assets will be free from tax from the first moment you make your account deposit. By contrast, while your after-tax money is in the 401(k), any earnings will be included in the taxable amount you pay when you withdraw funds -- even if those earnings came from your after-tax contribution.
Nevertheless, for those contemplating ways to get money into a Roth IRA without running afoul of the income limits, a 401(k) retirement plan rollover of after-tax contributions offers an interesting alternative. For some, it'll be the only available avenue to participate in the tax-free windfall that Roth IRAs provide.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
