Getting Your Financial Ducks In A Row

A new way to fund your Roth IRA

Photo courtesy of lee Scott on unsplash.com

Photo courtesy of lee Scott on unsplash.com

As you plan and save for your retirement, it’s nice to have multiple types of taxation for your income sources. You may have a pension, Social Security, and a traditional IRA, all of which are taxed to some degree or another.  Adding to this list you might have a Roth IRA which generally will provide you with tax-free income in retirement. The problem with the Roth IRA is that you have some strict limits on the amounts that you can contribute, and typical Roth Conversion strategies are costly and complicated. With the recent pronouncement from the IRS in Notice 2014-54, there is a brand new, sanctioned method, to fund your Roth IRA.

In the past, you could either make annual contributions of a maximum of $5,500 (for 2014 & 2015) or $6,500 if over age 50. These contributions are limited to folks with a MAGI less than $114,000 (if Single) or $181,000 (if married).

Another option for funding a Roth IRA is to rollover monies from an employer-sponsored Roth 401(k) plan, which some employers do not offer.

Lastly, you can make after-tax contributions to an IRA (again limited to $5,500 or $6,500) and then later convert the after-tax contributions to Roth. The problem with this one is that in order to do this completely tax-free you’ll need to ensure that the after-tax IRA contributions represent your ONLY IRA holdings when you get ready to convert. Otherwise you’ll get caught by the cream-in-the-coffee rule and have partial taxation of your conversion.

New Way To Fund Your Roth IRA

Now, with the information in Notice 2014-54, it becomes clear that you could (if your 401(k) administrator allows) make after-tax contributions to your 401(k) plan, and then when you leave employment rollover those post-tax contributions to a Roth IRA. (This goes for 403(b) and 457 plans as well.)

It’s not (as with many of these things) for the faint of heart, but it’s not rocket surgery either. First of all, your administrator has to allow after-tax contributions. Not all do, and if they don’t they may have to file an amendment to the plan in order to allow them.

Secondly, you have to make the contributions. Much like a Roth 401(k) contribution if you have that available, you are paying tax on the money before it is contributed to the account. Shouldn’t be a burden, as you’re paying tax on the income regardless, but it can be a concern for some because you have much more money “locked up” in the 401(k) plan that you don’t have access to. There is a limit to the total amount of money that you can divert into a 401(k) plan – for 2014 this limit is $52,000 or $57,500 if you’re over age 50. This limit is for the total of all 401(k) money for the year, so if you maximize your contributions ($23,000 if 50 or older, $17,500 otherwise) and your employer matches with $10,000 in contributions, you’d be limited to an additional $24,500 in after-tax contributions for the year.

Lastly, when you rollover the money (after leaving employment) you’ll need to handle this transaction carefully: All pre-tax contributions and the growth on both your pre-tax and after-tax contributions in the account should be rolled over to a traditional IRA. Then the after-tax contribution amount can be rolled over into your Roth IRA tax-free.

If you’ve done this number for a few years it can result in some significant sums to roll over and have available tax-free in the future.

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