Estate Planning Alert: Tax-free Transfer of After-Tax Retirement Plan Contributions to a Roth IRA


Contributions to a Roth IRA are after-tax, but a Roth IRA has the following advantages over a traditional IRA: (i) contributions can be withdrawn tax-free,

(ii) withdrawals of earnings are also tax-free if made after age 59 and more than five years after January 1 of the year in which the taxpayer first contributed to a Roth IRA, and

(iii) there are no minimum required distributions during the participants lifetime.

Some employer-sponsored 401(k) plans now permit after-tax Roth contributions, which offer the same advantages as a Roth IRA, but with much larger contribution limits, and other employer-sponsored plans provide for non-Roth after-tax contributions. The owner of an IRA that includes after-tax dollars cannot transfer only the after-tax portion of his or her account tax-free to a Roth IRA, because of the "cream in the coffee rule," which allocates all withdrawals pro rata between the taxable and non-taxable portions. For example, if an individual with $1,000,000 in traditional IRAs, including $100,000 of after-tax contributions, wants to move $100,000 to a Roth IRA, $90,000 of the $100,000 would be taxable. However, the IRS has recently issued Notice 2014-54, which permits a participant taking a distribution from an employer-sponsored retirement plan to separate out the taxable and non-taxable portions, rolling the former tax-free to a traditional IRA and the latter tax-free to a Roth IRA. If the above $1,000,000 account is instead in an employer-sponsored plan account instead of an IRA, $900,000 could be rolled to a traditional IRA and the remaining $100,000 to a Roth IRA, then $100,000 could be withdrawn tax-free from the Roth IRA.

The new IRS ruling provides an attractive opportunity for individuals with after-tax dollars in their employer-sponsored retirement plan accounts to enjoy the benefits of a Roth IRA without making a taxable Roth conversion.

Should you have any questions, please contact one of our estate planning attorneys.