After-Tax Assets in Qualified Retirement
James Lange, JD, CPA and
S. Skupien, JD
Recent amendments to the Internal Revenue Code1 governing
withdrawals from qualified retirement plans and tax-sheltered annuities
could provide some individuals with an entrée 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.
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
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
- with after-tax assets in a qualified
- whose incomes are below $100,000/year,
- who do not have an existing IRA.
The strategy also has potential for
individuals who have existing IRAs but these individuals face some
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
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
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
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
8 EGTTRA Section 642(a), amending Code Section 408(d)(3)(A).
Lange is a tax attorney and CPA who provides specialized retirement and estate
planning services to same sex couples with significant retirement plan accumulations. He
has prepared over 450 simple and complex retirement and estate plans. These plans
include tax-savvy advice, will and trust preparation, and sophisticated beneficiary
designations for IRAs and other retirement plans.
You can contact Jim by phone at (800) 387-1129,
or (412) 521-2732, or by e-mail at email@example.com.