After-Tax Accounts As a Path to Roth IRAs for High Earners

A new rule for retirement plan distributions makes way for high earners to get into Roth IRAs.

Under Roth individual retirement account (IRA) rules, only singles whose modified adjusted gross income (MAGI) is $131,000 or less in 2015, or married couples whose combined MAGI is $193,000 or less, can contribute to a Roth IRA.

However, a couple of months ago, the Internal Revenue Service (IRS) announced a rule that would allow certain high earners to earmark some of their savings as Roth after-tax amounts, according to a speaker at a webinar sponsored by retirement plan advisory firm Cafaro Greenleaf.               

David Flinchum, certified public accountant (CPA) and partner at Berlin, Ramos & Company, based in Rockville, Maryland, explains that Roth IRAs offer certain advantages for saving for retirement—earnings grow tax free, and there are no required minimum distributions (RMDs). But, high earners are not able to take advantage of Roth IRAs.

With IRS Notice 2014-54, plan sponsors have a new way to consider helping high earners get money into a Roth IRA, Flinchum says. The notice establishes a new rule allowing the direct rollover of after-tax contributions from a qualified retirement plan to a Roth IRA at the time of a distributable event.

Flinchum explains that there is a provision for 401(k) plans by which all employees are permitted to make non-deductible after-tax contributions into the plan. Voluntary after-tax contributions are different from Roth contributions: They do not have to come through payroll deduction, and while contributions are not taxed when withdrawn, earnings on those contributions are, so plans have to account for earnings separately. This type of contribution has been permitted for decades, he says, adding that voluntary after-tax contributions do not count towards the 402(g) maximum deferral limit, but do count for the 415 annual plan additions limit.

The IRS has always permitted after-tax accounts to be rolled into IRAs, but previously, that could not be done via a direct rollover; the plan participant had to receive a distribution first, and within 60 days would have to come up with the amount of taxes taken out of the after-tax account distribution to roll the total amount into a Roth IRA. Flinchum notes that earnings on voluntary after-tax account contributions must be rolled into a traditional IRA.

Should plan sponsors amend their plans to add voluntary after-tax contributions so high wage earners can get into a Roth IRA when their accounts are distributed? Flinchum says if a plan has a lot of high wage earners who are not part of the highly compensated employee (HCE) group for nondiscrimination testing, adding voluntary after-tax contributions can work well to help these high earners earmark savings for a Roth IRA. However, it wouldn’t work as well if the high earners in the plan are also HCEs, because having the HCEs contribute more would make nondiscrimination testing harder to pass—unless non-highly compensated employees (NHCEs) have high deferral rates.

For safe harbor plans, which generally do not require nondiscrimination testing, if the plan allows for voluntary after-tax contributions, plan sponsors must do an average contribution percentage (ACP) test for them. If no NHCEs make after-tax voluntary contributions, the test will fail.

Flinchum suggests plan sponsors discuss with their plan advisers or service providers whether the option should be offered in retirement plans. As all plans have to be restated by the spring of 2016, now is a good time to have the discussion, he says.