Making The Most Of Your 401(k) Plan — The Path To A “Back Door” Roth IRA

While most of us will never see a pension, the IRS has been expanding the opportunities for retirement savings using your 401(k) plan. Initially, there was only the opportunity to defer some of your salary into the plan in pre-tax dollars. That would allow the contribution — including the amount that would otherwise be paid in tax — to increase due to investment experience and allow the earnings to compound over the life of the account. Many employers tie the company contribution to the salary deferrals — offering a match — so that electing to defer salary results in an effective “return” on the contribution before it is even invested — essentially “free money.”

Then the IRS allowed the addition of a “Roth 401(k)” feature: the opportunity to pay the tax on the salary deferral up front in exchange for allowing the designated “Roth” money to grow tax-free (not tax-deferred) for as long as it is in the plan. Plus, it can be rolled into a Roth IRA which means the opportunity to qualify assets for tax-free distributions. Both types of salary deferrals are aggregated when determining the maximum set by law for the year. In 2015, the maximum is $18,000 with an additional catch-up of $6,000 available to those who are age 50 or older.

In most plans, employers also make contributions for the employee. As described above, they can match the salary deferrals, or they can allocate contributions over every employee in the plan. These latter contributions are called employer “elective contributions.” But even if they do, the amounts rarely add up to the overall limit set by law. For 2015, this limit is $53,000 per participant. (Caveat: The actual amount that is deductible must be calculated, so this is just a general rule.)

This brings us to another possible contribution which would take advantage of some of the unused limit. While generally unused, the IRS allows a qualified plan to add another feature called a “voluntary after-tax contribution” (“VATC”).  These contributions are taxed when they are contributed, and the earnings on them are taxed when distributed. The tax deferral for earnings is one clear advantage of making this contribution. Another is even more interesting: If a plan allows a VATC, that account may be used as a pathway to establishing a Roth IRA. This would have the effect of converting the account, after it is rolled out and tax is paid on the earnings, to one that will compound earnings tax-free.

Some have suggested that if the plan allows an in-service distribution, the participant could contribute the VATC, and then immediately ask for a distribution of the VATC, which would then be rolled into a Roth IRA. Since the VATC would not have been in the plan very long, it would not earn much to be taxed at distribution, and the VATC money, now in the Roth IRA, could start earning tax-free income almost immediately. The idea is great, but it is against IRS regulations unless the VATC money is the only money in the plan. Internal Revenue Code Section 402(c)(2) requires that if a participant has both pre-tax and after tax money in the plan, the distribution of less than all the participant’s accounts be treated as pre-tax or after–tax in proportion to the entirety of the participant’s accounts. For example, assume Ann contributes $20,000 as a VATC to her 401(k), and she has another $380,000 in pre-tax dollars. If she asks for a distribution of the $20,000, it would be treated as $1,000 in after-tax dollars and $19,000 in pre-tax dollars. $20,000 is five percent of the total of $400,000, so five percent of the $20,000 ($1,000) would be available to go into a Roth IRA. Not exactly what was intended.

However, last fall, the IRS issued Notice 2014-54 that reiterated the proportional rule, but gave savers another chance to achieve the result, but not until they retire. At retirement, all plan accounts are distributable. A participant can take a distribution of all his accounts, and directly roll the money in two separate parts, provided he gives advance notice to the Plan Administrator. In the example above, the participant can tell the Administrator to send the $20,000 to the Roth IRA and $380,000 to a Traditional IRA. (Prior to the IRS Notice, two checks would result in proportional allocations in each.)

If the participant asks for his whole account, but wants to rollover only part of the account, the amount rolled is considered all pre-tax (to the extent of the rollover) with the rest being after-tax plus any remaining pre-tax not rolled over. So if our participant with $400,000 takes out $100,000 cash to buy a yacht, and rolls the rest, the $300,000 rollover is considered all pre-tax, and the $100,000 distribution is considered $20,000 after-tax and $80,000 pre-tax.

The bottom line is that for those who are taking a long view, this allows another opportunity to fund a retirement account that would – provided the Roth IRA rules remain intact –never be subject to income tax.

Strauss Troy Attorney Claudia Allen advises clients on employee benefits and employment law matters. She can be reached by email at or by calling 513-629-9462.