Long-term savers have access to some of the most tax-efficient Roth IRAs. Roth IRAs offer tax-deferred growth and withdrawals after age 59 1/2 are tax-free if they have been held for at least five years. Roth IRAs don’t have to be distributed at the same time as other retirement accounts or IRAs.
However, not everyone can benefit greatly from a Roth IRA. You can only contribute $5,500 each year, while those over 50 can contribute $6,500. Higher-income earners, such as those who have a single income of over $131,000 or a married couple earning over $193,000, are not allowed to contribute to a Roth IRA.
This is the case, at least for now.
An earlier year rule created a loophole to these restrictions, allowing some people to make large Roth contributions. It is possible for anyone to do so, even those with incomes above the income limit.
Here’s why…
IRS Notice 2014-54 allows participants to transfer aftertax contributions to their 401(k), to a Roth IRA. This rule was effective January 2014 and retroactively applies to previous distributions.
This new rule is not available to everyone. However, those who are enrolled in a 401k plan that allows aftertax contributions and allows for withdrawals each year can benefit.
Here’s how…
First, make sure to top up your 401k plan with after-tax donations. For workers 50 years and older, $18,000 can be contributed from their pretax earnings to their 401k. Many 401(k), which allow aftertax contributions, permit you to make additional aftertax payments up to the IRS maximum $53,000 ($59,000 for those 50 years and older). If you are 50 years old and have contributed $24,000, and your employer matches $6,000, you may make an additional aftertax contribution in the amount of $29,000 ($59,000 less than the $24,000 or $6,000.
Next, rollover any additional after-tax contributions into a Roth IRA. It is best to do this right after any extra contributions have been made, so they don’t earn much or nothing. You will also need to withdraw the earnings from the aftertax money you have accumulated in the plan. Although withdrawn earnings are taxable, you can rollover untaxed earnings into a traditional IRA. This will ensure that the earnings won’t become taxable until they are withdrawn from the traditional IRA.
Before you can open a Roth IRA, you will need to be ready to deposit the after-tax money and invest it in the new account.
This is a decision you should make if it’s possible and makes sense in your particular situation. Before you move forward, consult your tax and financial advisor.
Don’t wait, because the Obama administration proposes legislation that will rein in this strategy.
