|
After-Tax Assets
in Qualified Retirement Plans -
New Opportunities
by: James
Lange, CPA, JD and Geraldine 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.
Two 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 pre-tax amounts.
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
For example:
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 for individuals:
- with after-tax
assets in a qualified retirement plan,
- whose incomes
are below $100,000/year, and
- who do not
have an existing IRA.
The strategy
also has potential for individuals who have existing IRAs but these
individuals face some additional constraints.
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 options.
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.
For example:
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.
Retired Employees
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 high.
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 plan.
Summary
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
subsection (H).
8 EGTTRA Section 642(a), amending Code Section 408(d)(3)(A).
|
