After-tax money in your 401(k)? Hate taxes? Read this.

With the market improving over the last couple of years, many baby boomers have shifted to contributing as much as they can into their 401(k) plans. In fact, this shift has even caused some to save beyond traditional tax-deductible limits, as they've invested post-tax dollars into their accounts in order to be in a better financial position during retirement.

But there's been an issue: Growth on these post-tax dollars that were saved in 401(k)s was eventually taxed ... or would have been, if not for new Internal Revenue Service guidance that reintroduces this powerful savings strategy to investors.


Internal Revenue Service building
Andrew Harrer | Bloomberg | Getty Images

The IRS recently issued what is known as Notice 2014-54, clarifying rules on how retirement-plan participants can allocate pre- and post-tax dollars to rollovers. Specifically, the notice clarified that after-tax dollars can be rolled directly into a Roth individual retirement account, unlocking tremendous potential for tax-free growth vs. simple tax-deferred growth.

How it works: A case study

Meet John. He's 54 years old and has been with ABC Corp. for nearly 35 years, now as a midlevel executive.

As he approaches retirement, he's focused on maxing out his 401(k) plan at $17,500 per year, in addition to the $5,500 catch-up contribution the IRS affords those over age 50. Since his plan allows for "after-tax" contributions over and above the typical IRS limits, he's deferred some of his income there as well. In fact, he's amassed $115,000 in after-tax monies over the years.

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His plan allows for a little-known but widely available provision called an "in-service withdrawal." This allows John the ability to draw out a portion of his 401(k) plan while still "in service" at the company.

Of his total $800,000 401(k) balance, John's 401(k) provider website specifies that $250,000 is available to take using the in-service feature. (Even if this feature wasn't available, he would simply wait until he attains age 59½ or fully separates from service at his company, typically whichever comes first.) Of that $250,000, $135,000 is pretax and $115,000 is after-tax.

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Ideally, a good advisor would try to create a powerful tax-free bucket of assets that can be used over time to help control John's tax bracket in retirement or for use as a legacy tool for his children. But how?

Through Notice 2014-54, issued Sept. 18, 2014, the IRS clarified retirement plan participant's options for treatment of assets at time of rollover.

Of the $250,000 available to invest outside of John's 401(k) plan, $135,000 of it can be directed to a traditional rollover IRA, with the other $115,000 directly rolled into a Roth IRA.

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While the $115,000 in after-tax money had some tax advantage inside of the 401(k) plan (in that growth on those dollars grew tax-deferred), now inside the Roth IRA they grow tax-free.

And while the IRS states that Notice 2014-54 will generally apply to distributions made on or after Jan. 1, 2015, it also notes that "in accordance with subsection 7805(b)(7), taxpayers are permitted to apply the proposed regulations to distributions made before the applicability date, so long as such earlier distributions are made on or after Sept. 18, 2014." This means John can start now.

Why choose a Roth IRA?

Here are a few reasons to choose a Roth IRA:

  1. Shelter more of your assets from taxation. By utilizing a Roth IRA, you can shift more of your assets into tax-favored status and thereby help control your taxable income from year-to-year during retirement. By having multiple "buckets" of money—some taxable, some not—you're able to more tightly control your own tax destiny.
  2. Tax exemption guaranteed. Due to the growing cost of Social Security and Medicare for baby boomers, many taxpayers believe tax rates will only increase in the future. Under current tax rules, your withdrawals in retirement from a Roth IRA will be exempt from taxes, even if future tax rates are higher than today's.
  3. Leave some wealth behind for your children. Traditional IRAs require that you withdraw a minimum amount once you reach 70½ and pay taxes on it, even if you don't need the money. Roth IRAs don't. Your savings can stay invested, tax-free and available to pass on to your children, although your beneficiaries must take minimum distributions after your death.

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You might be thinking that you make too much money to contribute to a Roth IRA, or that you can only contribute $5,500—or, if over age 50, an additional $1,000—for 2014.

And you'd be correct. But that doesn't matter as you convert the after-tax money from your retirement plan directly to a Roth IRA. As a rollover, the typical limitations do not apply.

What to do next

To take advantage of this, make an effort to save aggressively and, if your plan allows for it, you may wish to "clean out" these dollars periodically and convert them to a Roth IRA. (Note that this will typically carry along pretax dollars that should likely be rolled to a traditional rollover IRA.)

Even though Roth IRAs have some attractive features, they are not meant for everyone. Need more guidance? Contact your tax or financial professional, who can help make sense of all your options and help develop a successful retirement-planning strategy.


—By Gregory Ostrowski, special to CNBC.com. Ostrowski is a certified financial planner and managing partner at Scarborough Capital Management.