Moving money from a tax deferred retirement account to a potentially tax-free Roth IRA usually will trigger income tax. That won’t always be the case, though, thanks to recent IRS announcements. Some examples show how this can work. Example 1: Nancy Martin has participated in her company’s 401(k) plan for many years. She typically has made maximum pretax contributions to the plan. Nancy’s company allows employees to make additional aftertax contributions (many employers do), which she has done. Nancy decides to leave the company at a time when she has $600,000 in the 401(k), including $100,000 from aftertax contributions. Thanks to an IRS notice published in September (IRS Notice 2014-54), Nancy can have her plan administrator transfer $100,000 of aftertax money to a Roth IRA. Because this is aftertax money, Nancy won’t owe tax on the transfer. Inside her Roth IRA, untaxed growth can continue. Once Nancy has met the five year and age 59½ requirements, she can withdraw as much or as little from the Roth IRA as she wishes without owing any tax. In order to qualify for this tax treatment, Nancy’s Roth IRA transfer must be part of a distribution to two or more retirement accounts. Thus, she can send $100,000 to a Roth IRA and the other $500,000 to a traditional IRA. Nancy won’t owe any tax on these transfers. However, her $500,000 traditional IRA (and any future earnings) will remain pretax. Nancy will owe tax on any withdrawals from that traditional IRA or any future conversion to a Roth IRA.
Beyond 401(k)s, this strategy can be executed by taxpayers with aftertax money in other types of employer sponsored qualified plans.
What if Nancy already had rolled her $600,000 to a traditional IRA? In that case, any distributions from that account—including those for a Roth IRA conversion—would be considered a mix of aftertax and pretax money. If Nancy had $600,000 in a traditional IRA, with $100,000 of aftertax money, for instance, a $150,000 Roth IRA conversion would be considered $125,000 (5/6) taxable and $25,000 (1/6) untaxed. Nevertheless, there can be a way to execute a tax-free Roth conversion in that situation. Example 2: Assume that Nancy leaves the company and rolls her $600,000 401(k) balance to a traditional IRA. Currently, that IRA has the same balance, including $100,000 of aftertax money. Nancy has just accepted a new job with a company that sponsors a 401(k) plan for its employees. In this situation, Nancy can roll her $500,000 of pretax money into the new company’s 401(k) plan and then convert the aftertax $100,000 to a Roth IRA. Again, she’ll owe no tax on either move and she’ll have $100,000 in a potentially tax-free Roth IRA. That tactic has been possible in the past but not always practical: many employer plan administrators were reluctant to accept such rollovers from IRAs into a company retirement plan because the IRS had not explained how such transactions should be handled. That changed last year when the IRS published Revenue Ruling 2014-9, setting out the ground rules. Now, Nancy can have the custodian of her traditional IRA transfer up to $500,000 of her pretax money to the new company’s plan. Nancy also has to submit a statement to the administrator of the new plan, certifying that this rollover is all pretax money. Following Rev. Rul. 2014-9, company plans are likely to accept such rollovers from traditional IRAs. Please consult your 401k plan administrator before attempting a conversion as not all plan documents allow for these transactions.