Q: I am maxing out my 401(k). I understand there’s a new way to make after-tax contributions to a Roth IRA. How does that work?
A: You can thank the IRS for what is essentially a huge tax break for higher-income retirement savers, especially folks like yourself who are already maxing out contributions to tax-sheltered retirement plans.
A recent ruling by the IRS allows eligible workers to easily move after-tax contributions from their 401(k) or 403(b) plan to Roth IRAs when they exit their company plan. “With this new ruling, retirement savers are getting a huge increase in their ability contribute to a Roth IRA,” says Brian Holmes, president and CEO of investment advisory firm Signature Estate and Investment Advisors.
The Roth is a valuable income stream in retirement because contributions are after-tax, which means you don’t owe Uncle Sam anything on the money you withdraw. Unlike traditional IRAs which require you to start withdrawing money once you turn 70 ½, Roths have no mandatory distribution requirements, so your investments can continue to grow tax-free. And if you need to take a chunk out for a sudden big expense, such as medical bills, the withdrawal won’t bump you up into a higher tax bracket.
For high-income earners, the IRS ruling is especially good news. Singles with an adjusted gross income of $129,000 or more can’t directly contribute to a Roth IRA; for married couples, the income cap is $191,000. If you are are eligible to contribute to a Roth IRA, you can’t contribute more than $5,500 this year or next ($6,500 for people over 50). The IRS does allow people to convert traditional IRAs to Roth IRAs but you must pay income tax on your gains.
Now, with this new IRS ruling, you can put a lot more into a Roth by diverting your 401(k) assets into one. The annual limit on pre-tax contributions to 401(k) plans is $17,500 and $23,000 for people over 50; those limits rise to $18,000 and $24,000 next year. Including your pre-tax and post-tax contributions, as well as pre-tax employer matches, the total amount a worker can save in 401(k) and 403(b) plans is $52,000 and $57,500 for those 50 and older. (That amount will rise to $53,000 and $59,000 respectively in 2015.) When you leave your employer, you can separate the after-tax money and send it directly to a Roth, which can boost your tax-free savings by tens of thousands of dollars.
To take advantage of the new rule, your employer plan must allow after-tax contributions to your 401(k). About 53% of 401(k) plans allow both pre-tax and after- tax contributions, according to Rick Meigs, president of the 401(k) Help Center. You must also first max out your pre-tax contributions. The transfer to a Roth must be done at the same time you roll your existing 401(k)’s pre-tax savings into a traditional IRA.
The ability to put away more in a Roth is also good for people who want to leave money to heirs. Inherited Roth IRAs are free of tax, and because they don’t have taxable minimum required distributions, they can give your heirs decades of tax-free growth. “It’s absolutely the best asset to die with if you want to leave money behind,” says Holmes.
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