IRS Notice 2014-54 Authorizes Tax-Free Roth Conversions of After-Tax Plan Funds (After-Tax 401k Funds to a Roth IRA)

On September 18, 2014, the IRS published IRS Notice 2014-54, Guidance on Allocation of After-Tax Amounts to Rollovers. The IRS explains in this notice how taxation applies when a retirement plan participant takes both pre-tax and after-tax funds (this is not referring to Roth 401k funds but rather after- tax contributions where the earning grow tax deferred) from a qualified plan (for example, a 401k plan, 403b or 457b).

The most important takeaway from Notice 2014-54 is the freedom for qualified plan participants with both pre-tax and after-tax money in their employer plans, like full-time employer 401k plans and solo 401k plans (a type of 401k but for the self-employed), 403b plans, and 457b plans maintained by a governmental employer, to transfer the pre-tax and after-tax funds to different retirement accounts.

While IRS Notice 2014-54 allows for the allocation of pre-tax and after-tax money to any type of retirement account, for those who are self-employed and can thus open a solo 401k plan, it might be most beneficial to transfer the pre-tax portion to the pre-tax solo 401k bucket (i.e., the pre-tax solo 401k bank account), while at the same time allocating the after-tax portion to an after-tax solo 401k bucket (i.e., after-tax solo 401k bank account). By proceeding in this fashion, solo 401k owners will be able to retain the tax-deferred status on the pre-tax amounts of their distributions and simultaneously convert only the after-tax portions of their qualified plan distributions, tax-free. Subsequently, the solo 401k owner may choose to process an in-plan Roth Solo 401k conversion of the after tax funds. Once the after-tax funds have been converted to the Roth Solo 401k, all the gains will grow tax free.

Alternatively, the qualified plan participant with both pre-tax and after-tax plan funds can directly rollover the after-tax funds to a Roth IRA and then direct rollover their pre-tax money to a traditional IRA, per IRS Notice 2014-54.

Example:

John has $200,000 in his traditional 401k and separates from his employer. The balance of his 401k is made up of $120,000 of pre-tax salary deferrals and earnings, and $80,000 of after-tax contributions. John is eligible to request a distribution of all or some of his former employer 401k plan.

Because of IRS Notice 2014-54, John now has the option to split up the 401k distribution as follows: 1) have the pre-tax amount directly rolled over into a Traditional IRA, or a pre-tax solo 401k plan if John is self-employed; an 2) have the after-tax funds directly rolled over (converted) to a Roth IRA, or an after tax solo 401k. John can then process an in-plan Roth Solo 401k conversion of the after-tax funds.

COMPLIANCE NOTE: Notice 2014-54 does not apply to IRA distributions. You cannot convert only nondeductible IRA contributions to a Roth IRA if you also have traditional IRA funds. This is because the pro-rata tax rules apply to IRA distributions.

Fact:

Notice 2014-54 doesn’t change the way plan money is distributed. In other words, eligible distributions from plans are still subject to the pro-rata basis rules.

Example:

Ben has $75,000 in his Solo 401k plan that is all eligible for distribution. Ben’s balance is made up of $50,000 of pre-tax salary deferrals and $25,000 of after tax contributions. Benjamin decides to take a distribution of $25,000. He cannot distribute only his $25,000 of after-tax funds. Instead, the $25,000 solo 401k distribution will be made up of a proportionate amount of pre-tax and after-tax funds, as was the rule prior to Notice 2014-54. In sum, the notice does not affect the way pre-tax and after-tax money flow out of the plan.

Summary of Key Points

In Notice 2014-54 the IRS states that clients with both pre-tax and after-tax money in their employer plans (this also includes solo 401k plans since they fall under the employer plan umbrella) can allocate the pre-tax portions of their plan distributions to traditional IRA rollovers and after-tax portions of their distributions to tax-free Roth IRA conversions.

Plan participants who took plan distributions before to the issuance of Notice 2014-54, as well as those taking such distributions before the end of the year, can generally use a reasonable method to allocate pre-tax and after-tax funds. 

Notice 2014-54 did not change the way money is distributed. Such distributions are still made on a pro-rata basis from the funds in a participant’s account that’s eligible for distribution.

The guidance in Notice 2014-54 does not apply to IRA distributions. 

Many plans only allow participants to make one direct rollover per distribution. If that is case, participants wishing to segregate their pre-tax and after-tax funds to do tax free Roth IRA conversions should directly roll their pre-tax funds to a traditional IRA and do a 60-day rollover of their after-tax funds to a Roth IRA.

The ability for a plan participant to make after-tax contributions is largely up to the plan. Such contributions are not subject to the $18,000 cap of pre-tax/plan Roth salary deferrals, but are subject to the $53,000 overall limit (2016 cap overall limit). Note that while not all full-time employer plan sponsors offer plans that allow for after-tax contributions, My Solo 401k Financial offers a self-employed plan that can accept after-tax contributions.

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