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5 Things to Know About the New Roth IRA Rule

In case you missed it: The Internal Revenue Service (IRS) announced a new rule recently that allows high-income earners to rollover after-tax money from their 401(k)s directly into a Roth individual retirement account (IRA) – tax free.

Typically, the money you contribute to an employer-sponsored retirement plan such as a 401(k) is in pretax dollars. Depending on your income, the new Roth IRA rollover option may be an incentive to build up your 401(k) even more with additional after-tax savings.

Before this rule change, individuals with adjusted gross incomes of $129,000 or more and couples with incomes of $191,000 or more had no way to directly contribute to a Roth IRA. 

Roth IRAs are unique in that contributions can grow tax free and withdrawals are not taxed, nor do they count against your adjusted gross income. Also, when you turn 70 ½, you benefit even more because Roth accounts, unlike traditional IRAs, are not subjected to required minimum distributions.

Therefore, the recent change could make it easier for high-income earners to access the tax benefits of a Roth IRA.

The new rule is set to go into effect next year, but if you are currently eligible to rollover your 401(k) you can make transfers right now. If inclined, you can read the full ruling, in all its glorified legalese, in Notice 2014-54. For those that prefer plain talk, here are the 5 key things to know:

  1. High-income earners can now directly move money into a Roth IRA, tax free, by transferring after-tax contributions from their employer-sponsored plans.
  2. The transfer of after-tax contributions to a Roth IRA must be made at the same time as the transfer of pretax contributions into a traditional IRA.
  3. In order to make after-tax contributions, you must first contribute the maximum pretax amount to your 401(k) plan.
  4. In 2015, annual pretax contribution limits to 401(k) plans increase to $18,000 for individuals under age 50 and $24,000 for those age 50 and older. The total amount a worker can save annually in such accounts – including pretax contributions, pretax employer matches and after-tax contributions – is $53,000 for those under age 50 and $59,000 for workers age 50 and older.
  5. With the option to contribute to a Roth account directly, high-income savers may avoid complex “backdoor” Roth IRA conversions.

One important takeaway from this rule change is that you cannot avoid taxes on your retirement savings. You either pay now or later. In the case of Roth IRAs, contributing after-tax money means you are paying taxes now rather than later when you withdraw money tax free. Since money in retirement accounts are taxed as income, it’s best to convert to a Roth IRA when your income is lowest. We recommend seeking tax counsel to determine if this option makes sense for your individual situation.

Another takeaway is that we do not know how the government will change tax rules in the future. They may decrease or increase your tax burden. The uncertainty of future tax laws is a risk and one reason why tax strategies such as tax-loss harvesting and asset location don’t always work as planned.

If you would like to learn more about Roth conversions, check out this blog post: Making Sense of Roth Conversions.