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Roth IRA: Part of a major new tax-savings rule from the IRS

Roth IRA accounts are a big part of new guidance from the IRS on long-term retirement savings. A new rule allows for the after-tax portion of 401(k) plans to be separated from the pre-tax portion and moved into a Roth IRA, resulting in tax-free growth from then on for that account.

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    Retiree Jerry Hallman talks about water quality and the Colorado River Municipal Water District in Big Spring, Texas. New guidance from the IRS allows for the after-tax portion of traditional 401(k) plans to be separated from the pre-tax portion and moved into a Roth IRA, resulting in more robust tax-free growth.
    Torin Halsey/The Wichita Times-Record-News/AP/File
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The Internal Revenue Service has recently issued guidance that presents a significant tax-saving opportunity for investors who have made non-deductible (after-tax) contributions within a 401(k) or Traditional Individual Retirement Account.

Most of the time, when a contribution is made to a 401(k) or Traditional IRA, the investor receives a deduction for the full amount of the contribution. The money then grows tax-deferred and taxes are paid both on the contribution and growth when a distribution is made, typically in retirement.

Conversely, some investors use Roth options, which do not provide a tax deduction when the contribution is made, but allow for tax-free growth and withdrawal in retirement, subject to a few rules.

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A non-deductible contribution represents money that is put into the former, a 401(k) plan or Traditional IRA, but due to varying circumstances, the investor is not allowed to deduct the contribution. As a result, the original contribution is not taxed on distribution, but the growth is.

This ends up being the worst of both worlds. There is no tax-deduction and no tax-free growth. The only advantage is the deferral of taxes until distribution. The result is in an account that has a portion of after-tax money (also called “basis”) that continues to generate growth that will someday be taxed. When the funds are withdrawn, the growth and basis are considered to be distributed pro-rata, resulting in a distribution that is only partly taxable, depending on the current balance of pre-tax and after-tax dollars in the account.

With the recent guidance, the IRS has allowed for the after-tax portion of 401(k) plans to be separated from the pre-tax portion and moved into a Roth IRA, resulting in tax-free growth from then on for that account. This is different than a Roth Conversion and, consequently, has different rules and implications.

This split can be done through either an in-service distribution or upon retirement, though earlier is better to allow for longer tax-free growth within the Roth IRA. According to the IRS, the distribution from the 401(k) still occurs pro-rata with both pre-tax and after-tax dollars coming out. However, the guidance allows the pre-tax dollars to be directed into an IRA rollover, while the after-tax dollars go into a Roth IRA. Neither of these events is taxable.

Unfortunately, this method cannot be used directly for investors who have non-deductible contributions in an IRA. But there is an indirect strategy that may work in certain circumstances. If someone has a 401(k) in addition to an IRA rollover, he may be able to roll the pre-tax IRA assets into the 401(k), leaving the after-tax assets, which can then be converted tax-free into a Roth IRA. Of course, this strategy requires a 401(k) plan to be effective.

Investors without a 401(k) plan may convert IRA assets directly into a Roth IRA, but the conversion is pro-rata, meaning the assets that are converted will consist of both pre-tax and post-tax dollars, resulting in tax liability for the pre-tax portion. Also note that for the purposes of the pro-rata determination, the IRS looks at the collective value of all IRAs owned by the taxpayer, so it does not matter which IRA the conversion comes from.

The ability to move after-tax contributions into a Roth IRA presents an opportunity for significant long-term tax savings. This recent guidance goes a long ways to clarifying a process that tax preparers and investors have speculated about and tiptoed through for years.

The post IRS Offers Tax-Saving Option for Retirement Contributions appeared first onNerdWallet News.

Learn more about David on NerdWallet’s Ask an Advisor.

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