Recent amendments to the Internal Revenue Code1 governing withdrawals from qualified retirement plans and tax-sheltered annuities could provide some individuals with an entree into the world of Roth IRAs and tax-free growth. Individuals who have accumulated after-tax assets in their employer sponsored retirement accounts may qualify for an unparalleled opportunity to convert the growth on those assets from tax-deferred to tax-free.
Two groups of people can benefit:
- Active employees with available after-tax assets in qualified retirement plans such as pensions, 401(k)s, and 403(b)s.
- Retired employees who can take a lump-sum distribution from a qualified plan or tax-sheltered annuity.
Although the amendments apply to all qualified plans, certain plan contracts (set by the employer and the company that administers the plan) may not have the necessary provisions to make the strategy effective. Individuals who qualify for a Roth IRA conversion should check to see if their qualified plans:
- Allow after-tax contributions.
- Allow active employees to make withdrawals of the after-tax amounts from their plans for reasons other than hardship.2 Many plans allow active employees to take distributions of after-tax dollars, but not distributions of pre-tax amounts.
Active Employees Making Ongoing Retirement Plan Contributions
After-tax funds accumulate in a retirement account in two ways:
- Money was contributed to certain plans prior to mid-1986 when the IRS did not allow a tax deduction for the contribution but did allow tax-deferred growth.
- The plan allows employees to contribute additional money to the account beyond the current allowable tax deferred contribution of $11,000 per year.3
Consider a retirement plan that allows employees to contribute up to 15% of their salary. Assume an employee makes $90,000/year. A contribution of 15% of this salary equals $13,500 and exceeds the $11,000 limit on tax-deferred contributions to 403(b) plans by $2,500. The employee wishing to shelter the most money allowed would contribute $11,000 on a pre-tax basis (which would not be included in his W-2 for federal income tax purposes), and $2,500 after-tax, which would be included in his W-2 income.
Prior to this year, removing the after-tax assets from the tax-deferred environment did not serve most people’s retirement objectives. If a participant were to remove the money to invest it independently, despite the fact that there would be no income tax on the distribution, the investment would generate income tax on the subsequent interest, dividends or capital gains. Leaving the money in the fund to grow tax-deferred was the better option.
The new tax law (amended in 2001 to take effect in 2002) has changed the picture. There is a golden opportunity for individuals:
- with after-tax assets in a qualified retirement plan,
- whose incomes are below $100,000/year, and
- who do not have an existing IRA.
The strategy also has potential for individuals who have existing IRAs but these individuals face some additional constraints.
Roth IRA Conversions for Individuals Without Existing IRAs
Individuals with modified adjusted gross incomes below $100,000 who do not have an IRA can roll the after-tax money from their qualified retirement plan into a traditional IRA. In this instance, the IRA would be funded solely with after-tax contributions. This type of IRA is sometimes referred to as a nondeductible IRA.4 Once this IRA is established, it is then possible to convert it into a Roth IRA.
In this example, the only money we are rolling over is the after-tax portion of the retirement plan. If the entire retirement plan were rolled into an IRA, the IRA would contain both pre-tax and after-tax portions. After-tax amounts in an IRA are referred to as its “basis.” In this case, the basis of the IRA is equal to its total value. Since taxes have been paid on the full amount of this nondeductible IRA, there will be no additional tax upon conversion to a Roth IRA.
The real advantage of this rollover and Roth IRA conversion is that the Roth IRA will grow income tax free, not income tax deferred, as it would in the plan. Plus, there are the additional benefits that come with a Roth IRA, i.e., no minimum required distributions at 70½ and the extended advantage of continued tax-free growth on an inherited Roth IRA. The chart in Figure 1 shows the advantage in total spending power which results from accumulating money in a Roth IRA rather than as a nondeductible basis contribution in a traditional IRA. Unless there are extenuating circumstances, everyone who qualifies should do it.
Roth IRA Conversions for Individuals with Existing IRAs
For individuals with existing IRAs who meet the income limitations for a Roth conversion, the tax law is clear: although you can roll the after-tax assets from your qualified retirement plan into an IRA, you can’t convert your after-tax contributions to a Roth IRA without converting and paying taxes on a pro rata portion of your tax-deferred assets as well. But you still have options.
There is an important concept that needs to be understood in order to make sense of the above constraint. No matter how many IRA accounts you may have, the Tax Code considers all your IRA money to be in “one pot.” Any already taxed money in the IRA environment is your basis, regardless of which specific IRA account contains the after-tax money. For every dollar removed from the IRA environment, the ratio of your total after-tax assets to your total tax-deferred assets determines the proportion of the distribution that is taxed. If you have 400 taxable dollars and 100 nontaxable dollars in IRAs and you take out five dollars, four dollars of the distribution are taxed and one dollar is not.
The taxable portion is computed using Form 8606. This is the same form you file when you make a nondeductible contribution to an IRA to keep track of your basis (the already taxed dollars). Another important point to remember is that you must keep good records of your nondeductible contributions. As far as the IRS is concerned, any withdrawals from an IRA are presumed to be fully taxable unless proven otherwise. If you have a basis in your IRA(s) and you take a distribution, you may be required to prove the basis with copies of your Forms 8606 or your tax returns.
Given that, you still might want to consider rolling the after-tax money from the qualified retirement plan into an IRA, but you will need to plan ahead to figure out if a Roth IRA conversion is feasible. Figure out the ratio of your basis to your tax-deferred assets. Consider converting as much as you are willing to pay taxes on.
Assume you have a traditional IRA of $10,000 (fully taxable). Also, please assume you have $30,000 in the after-tax or nondeductible portion of your 401(k). You roll the $30,000 into a nondeductible IRA. If you were to convert both the deductible ($10,000) and the nondeductible ($30,000) of your IRAs to a Roth IRA, you would only have to pay tax on converting the $10,000. You end up with a $40,000 Roth IRA, and you have only paid income tax on $10,000.
Another scenario might be:
After the rollover of the nontaxable portion of your 401(k), you now have $50,000 in your IRA: $30,000 in nondeductible contributions and $20,000 in tax-deferred contributions. In this example, your ratio of basis to tax-deferred dollars is 60/40. But assume you are only willing to pay taxes on a $10,000 Roth IRA conversion. In that case, you could convert $25,000 to a Roth IRA-$15,000 would be your basis (no tax due) and you would owe taxes on $10,000. You end up with $25,000 in a Roth IRA and all the benefits of tax-free growth and $25,000 remaining in a traditional IRA. (See James Lange’s article, Roth IRAs: Accumulating Tax-Free Wealth, May 1998, The Tax Adviser (1998 by The American Institute of Certified Public Accountants).
Individuals Whose Income Exceeds the Roth Conversion Limits
For individuals with incomes over $100,000 who do not qualify for a Roth IRA conversion, there is no compelling tax reason to make the rollover from a qualified plan into an IRA. Both plans provide the same opportunity for tax-deferred growth. However, you still may consider rolling the nondeductible portion of your money into an IRA for investment reasons, knowing full well there are no income tax benefits.
Another set of participants who could benefit from the tax changes, perhaps in a more substantial way, are individuals who can take a lump-sum distribution from either their pension or their employer retirement plan-presumably retired employees.
Until this year, if you chose to take a lump-sum distribution from a qualified plan that contained tax-deferred assets as well as after-tax assets, you could roll the tax-deferred portion of the distribution (your own pre-tax contributions and the company’s contributions) into an IRA, but you couldn’t roll your after-tax dollars into an IRA.5
Beginning in 2002, you can roll the full amount (both pre-tax and after-tax portions) of a qualified plan distribution into an IRA.6 Once in an IRA, these after-tax amounts can continue to grow tax-deferred just as they had inside the plan. Later, if you decide to convert your traditional IRA to a Roth IRA, the after-tax portion (which has already been taxed) can be converted to a Roth without tax. However, you have the same problem as before. You can’t simply convert the “after-tax” portion of the IRA.
Therefore, converting to a Roth IRA is unlikely to seem desirable to participants with large qualified plan balances. For example, let’s assume someone has $500,000 in his or her employer retirement fund of which $50,000 is in the after-tax category. The retiring employee can roll the entire amount into a traditional IRA and then to a Roth IRA, but can’t split the money up and convert only the nontaxable portion leaving the taxable portion in the traditional IRA. It is true that if the employee wanted to make a $500,000 conversion that he or she would only have to pay tax on $450,000, but few participants will want to make that conversion-the taxes are too high.
However, even without the motivation of converting to a Roth IRA, there are still reasons to roll money out of a qualified plan, 401(k), or 403 (b). Under the new tax law, a retiree can roll the pre-tax and post-tax assets from his or her employer plan into an IRA and continue to enjoy tax-deferred growth on the after-tax portion of the funds. This strategy is especially prudent if the employer plan limits how plan beneficiaries can take distributions. Although tax law sets the general rules that govern retirement plans, the plans themselves can subject participants to additional rules. Some plans offer less than optimal distribution choices when the beneficiary is not the spouse of the participant. For example, some employer plans require that a non-spouse beneficiary take a lump sum distribution of the remaining retirement assets during the year that follows the participant’s death. Under these circumstances, the non-spouse beneficiary is required to pay all the income taxes due on the money at the time of the distribution. If the participant were to roll the money out of the employer plan and into an IRA before death, the rules for how beneficiaries can take distributions are much more flexible.
As a practical matter, most retiring employees often prefer to take their after-tax money up front-there is no income tax on the money and there are retirement activities to pursue. It also simplifies future accounting for taxable and nontaxable portions of withdrawals. Ultimately, the after-tax funds might be best used to pay the income taxes on a Roth IRA conversion of a portion of the deductible IRA. However, in some situations, the additional tax deferral would be preferable. Assessing the merits of a post retirement Roth IRA conversion is dependent on individual circumstances and is beyond the scope of this article.
However, there is still an interesting course of action for retirement plan participants taking a lump sum distribution. The new tax bill has one more significant provision that allows the participant to do in several steps what he or she could not do in one step. Consider the following:
A participant with both pre-tax and after-tax money in a qualified plan or tax-sheltered annuity takes a lump-sum distribution and rolls the entire amount into a traditional IRA, which the tax law now allows. If the employee goes back to work or becomes self-employed and the plan of the new employer allows it, he or she can roll back the taxable amounts from the traditional IRA into the qualified plan of the new employer. The most likely scenario is if a retiree does some consulting and sets up his own retirement plan.
The allocation rules for rolling a traditional IRA, like the one above, back to a qualified plan have been changed. The entire rollover distribution is presumed to be the taxable portion.7 In fact, the already taxed amounts cannot be rolled back into a qualified plan.8 The result? All the remaining amounts in the traditional IRA are already taxed dollars and can be converted to a Roth without tax. The amount rolled back into the new employer’s plan will grow tax deferred. The employee has the best of both worlds: a “free” Roth IRA conversion and the balance in a qualified plan.
Active employees with after-tax dollars in their 401(k) or 403(b), whose plan allows them to roll the money into a nondeductible IRA, who have no other traditional IRAs, and who qualify for a Roth IRA conversion, should take the steps to make the Roth conversion. Employees in a similar situation who have traditional IRAs should probably do so, but it may not be as favorable. Finally, retirees in some situations will benefit from the new law, but individuals may also choose to take the tax-free money and run.
1 The Economic Growth and Tax Relief Act of 2001 (“EGTRRA”).
2 EGTRRA Section 636(b), amending Code Section 402(c)(4) to provide that a hardship distribution is not an eligible rollover distribution.
3 EGTRRA Section 611(d), amending Code Section 402(g)(1).
4 Code Section 408(d)(1), (d)(2).
5 Code Section 402(c)(2) prior to amendment.
6 Code Section 402(c)(2) as amended.
7 EGTTRA Section 643(c), amending Code Section 408(d)(3) by adding subsection (H).
8 EGTTRA Section 642(a), amending Code Section 408(d)(3)(A).