Why 2015 Will Be the Year of the Roth: Meet the “Freight Entrance” Roth 401(k) Conversion
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Two new tax rules will affect the treatment of 401(k) monies. Taken individually, the rules were not particularly far-reaching or noteworthy, but together they will reshape the retirement-planning landscape. Roth IRA conversions that previously trickled through the cumbersome “backdoor” will be supplanted by a new wave moving through the “freight entrance.”
The first change, in January 2013, was a provision in the American Taxpayer Relief Act of 2012 (Section 902) that affords 401(k) plan participants the same ability to convert traditional (pre-tax) 401(k) money to a Roth 401(k) that traditional IRA holders have in converting to Roth IRAs. As with Roth IRA conversions, whatever portion of one’s traditional 401(k) account is converted is subject to ordinary income tax -- but no penalty -- in the year of the conversion. From the IRS’ perspective, one can see how such conversion would generate tax revenue. However, as a practical matter, few traditional 401(k) participants have been compelled to effect such “in-plan conversions” because of the income taxes that would be due from out-of-pocket savings.
The second change came with the issuance of IRS Notice 2014-54 in September 2014. In this notice, the IRS stated that it will allow plan participants who have after-tax contribution money in their 401(k) accounts to convert this money to a Roth IRA upon separation of service from their employer without being subject to the pro-rata tax rules that normally apply to so-called back-door Roth conversions. The conversion must be made concurrently with the direct rollover of the participants’ other traditional and Roth 401(k) money. This change is regarded as a boon to 401(k) participants who may have after-tax contribution money from old (generally pre-1978) thrift plans. Before this rule, retiring plan participants had little choice but to roll after-tax thrift money into their traditional IRAs and either distribute in accordance with the pro-rata distribution rule or, worse, pay tax (again!) on this after-tax money as it is distributed.
At first, IRS Notice 2014-54 was not regarded as particularly Earth-shattering, since the segment of the working population with after-tax 401(k) contribution money from these ancient plans is relatively small. However, more careful deliberation shows that this rule may have far broader implications.
Understanding this requires a review of the early days of defined-contributions plans in the mid-1970s. At that time, retirement plans were primarily employer-funded profit sharing and/or money-purchase pension arrangements, though employees were permitted to participate as well through discretionary after-tax contributions. This privilege was effectively rendered obsolete with the 1978 enactment of IRC Section 401(k) permitting plan participants to make pre-tax salary deferral contributions. The introduction of the Roth 401(k) in 2006 rendered the notion of making separate after-tax discretionary contributions to a traditional 401(k) even less appealing. As a result, while the right of plan participants to make discretionary after-tax contributions in addition to their 401(k) and Roth 401(k) salary deferrals never really went away, it has remained an obscure, forgotten provision of most modern plan documents – until now.
What truly is Earth-shattering is that, per the combined application of IRS Notice 2014-54 and Section 902 of the American Taxpayer Relief Act of 2012, plan participants who have already contributed the maximum salary deferral limit to a 401(k) account ($18,000 for participants under age 50; $24,000 for participants age 50+) could theoretically make an additional discretionary contribution from personal savings of up to $35,000 (assuming no employer contributions) to reach the total $53,000 ($59,000 for participants age 50+) permitted in a single year to a defined-contribution plan. The participant could then immediately elect to process an in-plan Roth 401(k) conversion of the after-tax contributions to his/her Roth 401(k) with no income tax due.