After Tax Rollover Rules: Helpful and Taxpayer Friendly
While not widely used or known, some employer sponsored retirement plans, including pilot 401(k) plans, allow you to put after‐tax money into the account. This is different from a Roth 401(k), which is also after‐tax but subject to salary deferral contribution limits. These after‐tax contributions may be made in excess of deferral limits ($19,500 for 2020) up to the annual defined contribution plan limit ($57,000 in 2020) and, once in the account, they grow tax free like a Roth. IRS ruling, Notice 2014‐54, makes rolling after‐tax money out of a 401(k) easier—allowing pilots to maximize the value of their plan. Here’s how it works, if you have invested after‐tax money in your 401(k) plan, the rule allows:
- After‐tax money to be rolled into a Roth IRA;
- Money grows tax‐free; and
- Pre‐tax money rolls tax‐free simultaneously to a regular IRA.
The example in the Notice discusses a 401(k) account where an employee has a $250,000 balance consisting of $200,000 of pre‐tax savings and $50,000 of after‐tax savings. The employee quits, retires or is fired (“separates from service”) and requests a distribution of $100,000. The distribution is split proportionally. The pre‐tax amount is $80,000 and the after‐tax amount is $20,000. The result under the new rules: “The employee is permitted to allocate the $80,000 that consists entirely of pre‐tax amounts to the traditional IRA so that the $20,000 rolled over to the Roth IRA consists entirely of after‐tax amounts.” You can now direct pre‐tax dollars to one place and after‐tax dollars to another and it will still be treated as a single distribution.
This benefits higher‐income individuals, like pilots, who are able to make contributions in excess of the pre‐tax limit ($19,500 annually, $26,000 with catch‐up contributions) to save more. Pilots can make after‐tax contributions knowing that their savings can be rolled directly into a Roth IRA later when they leave their 401(k) plan without tax consequences and complexities. Because higher wage earners can be limited in the amount they put in a Roth (or may not be able to participate at all), the ability to make excess contributions which can later be rolled into a Roth without income restrictions creates a tax‐free retirement income source for the future. Many people choose to save with traditional 401(k) pre‐tax contributions to get the immediate tax benefit of the deduction. But modeling indicates that by implementing tax diversification ahead of time, contributing after‐tax money (non‐Roth) to your 401(k), you can create savings withdrawals that are tax‐free later instead of all taxable withdrawals giving yourself more options.
Please read the article where I discuss the advantages of a tax diversification strategy for retirement savings, The Art of Retirement Income: Making the Most of Your Savings. Those 10 to 15 years away from retirement should consider implementing a tax diversification strategy for your retirement savings. Please consult your tax advisor as well as a qualified retirement plan advisor to best understand how to maximize your savings as well as how to create a retirement income stream based on savings with varied tax treatments.
by Robert Warner
Robert Warner is Managing Director, The Pilot Program, Johnson Financial Group and EVP Johnson Wealth, a Johnson Financial Group Company. He is also a Chartered Financial Consultant (ChFC®). He has over 25 years experience helping clients, including active pilots and their families achieve their retirement and estate planning goals with an emphasis on estate conservation and wealth transfer planning.READ MORE about Bob Warner.
Johnson Financial Group and its subsidiaries do not provide tax advice. Please consult your tax advisor with respect to your personal situation. Wealth management services are provided through Johnson Bank and Johnson Wealth Inc., Johnson Financial Group companies. Additional information about Johnson Wealth Inc., a registered investment adviser, and its investment adviser representatives is available at https://www.adviserinfo.sec.gov/. NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE