Let’s talk
this time about a tax trick that may be available to you if you participate in
a 401(k). The reason for the “may” is that – while the tax Code permits it –
your individual plan may not. You have to inquire.
Let’s set it
up.
How much
money can you put into your 401(k) for 2015?
The answer
is $18,000. If you are age 50 or over you can contribute an additional $6,000,
meaning that you can put away up to $24,000.
Most
401(k)’s are tax-deductible. There are also Roth 401(k)’s. You do not get a tax
break like you would with a regular 401(k), but you are putting away
considerably more than you could with just a Roth IRA contribution.
Did you know
that you might be able to put away more than $18,000 into your 401(k)?
How?
It has to do
with tax arcana. A 401(k) is a type of “defined contribution” (DC) plan under
the tax Code. One is allowed to contribute up to $53,000 to a DC plan for 2015.
What happens
to the difference between the $18,000 and the $53,000?
It depends. While
the IRS says that one can go up to $53,000, your particular plan may not allow
it. Your plan may cut you off at $18,000.
But there
are many plans that will allow.
Now we have
something - if you can free-up the money.
Let’s say you
max-out your 401(k). Your company also contributes $3,000. Combine the two and
you have $21,000 ($18,000 plus $3,000) going to your 401(k) account. Subtract
$21,000 from $53,000, leaving $32,000 that can you put in as a “post-tax”
contribution.
Did you
notice that I said “post-tax” and not “Roth?” The reason is that a Roth 401(k) is
limited to $18,000 just like a regular 401(k). While the money is after-tax, it
is not yet “Roth.”
How do you
make it Roth?
Prior to
2015, there had been much debate on how to do this and whether it could even be
done. The issue was the interaction of the standard pro-rata rules for plan
distributions with the unique ordering rule of Code Section 402(c)(2).
In general,
the pro-rata rule requires you to calculate a pre- and post-tax percentage and
then multiply that percentage times any distribution from a plan.
EXAMPLE: You have $100,000 in your 401(k). $80,000 is from
deductible contributions, and $20,000 is from nondeductible. You want to roll
$20,000 into a Roth account. You request the plan trustee to write you a
$20,000 check, which you promptly deposit in a newly-opened Roth IRA account.
Will
this work?
Through 2014 there was considerable doubt. It appeared that
you were to calculate the following percentage: $20,000/$100,000 = 20%. This
meant that only 20% of the $20,000 was sourced to nondeductible contributions.
The remaining $16,000 was from deductible contributions, meaning that you had
$16,000 of taxable income when you transferred the $20,000 to the Roth IRA.
I admit, this
is an esoteric tax trap.
But a trap it
was.
There were
advisors who argued that there were ways to avoid this result. The problem was that
no one was sure, and the IRS appeared to disagree with these advisors in Notice
2009-68. Most tax planners like to keep their tires on the pavement (so as not
to get sued), so there was a big chill on what to do.
The IRS then
issued Notice 2014-54 last September.
The IRS has
clarified that the 401(k) can make two trustee-to-trustee disbursements: one
for $80,000 (for the deductible part) and another of $20,000 (for the
nondeductible). No more of that pro-rata percentage stuff.
There is one
caveat: you have to zero-out the account if you want this result.
Starting in
2015, tax planners now have an answer.
Let’s loop
back to where we started this discussion.
Let’s say
that you make pretty good money. You are age 55. You sock away $59,000 in your
401(k) for five years. Wait, how did we get from $53,000 to $59,000? You are
over age 50, so your DC limit is $59,000 (that is, $53,000 plus the $6,000 catch-up).
Your first $24,000 is garden-variety deductible, as you do not have a Roth
option. The remaining $35,000 is nondeductible. After 5 years you have $175,000
(that is, $35,000 times 5) you can potentially move to a Roth IRA. You may have
to leave the company to do it, but that is another discussion.
Not a bad
tax trick, though.
