Rolling Voluntary 401(k) After-Tax Money To Roth IRA

May 01, 2023

Using after-tax 401(k) contributions to execute backdoor conversions to a Roth IRA can be an effective strategy if you want to utilize these funds to retire early. When do employees think about executing this strategy?  Consider the following factors:

  • You want to retire early
  • A large portion of your net worth is tied up in retirement accounts
  • Your work retirement plan allows for after-tax contributions to your 401(k) into a separate account
  • Your plan also allows in-service direct rollovers from the after-tax account to a retirement account outside of the plan
  • You have (or will have) savings or investments in outside retirement accounts that can help to supplement your early retirement

The Basics

At a fundamental level, after-tax Roth IRA conversions allow folks who retire early access to retirement principal without the 10% penalty typically assessed on early withdrawals from these accounts.

In a Roth IRA, you can access contributions anytime because you have already paid tax on the money. You can access the after-tax conversion basis directly rolled into your Roth IRA from your 401(k) without penalty as well. However, each taxable conversion has its own 5-year rule, and if you withdraw the funds within the first five years, unless you have a qualifying reason, the withdrawal may be penalized.

Investments in Roth IRAs have the potential to grow with the market, and earnings are distributed tax-free as long as you hold the account until the age of 59.5 or 5 years, whichever is longer. You may be able to withdraw from your Roth IRA if you have a qualifying reason to take the money out.

Early withdrawals are subject to Roth IRA ordering rules for distribution:

  1. Contributions
  2. Conversions (taxable then after-tax)
  3. Earnings

Seek tax advice before any conversion so you understand the tax implications for your specific situation.

After-tax Contributions to Work Retirement Plans

Certain employer retirement plans allow employees to make three types of contributions:

  1. Pre-tax/regular
  2. Roth
  3. After-tax voluntary

Employees can contribute up to $22,500 (plus a $7,500 catch-up contribution if over 50 years of age) to the pre-tax and/or Roth 401(k) portion of the retirement plan in 2023.

In addition, if your plan allows it and depending on if your employer contributes or not, you may be able to contribute up to another $43,500 to the after-tax voluntary bucket. The IRS aggregate limit of employer and employee contribution increased to $66,000 in 2023 for most workplace retirement plan accounts like 401(k)s.

Use the following equation to figure out how much you can contribute to the after-tax bucket in your retirement plan through work:

After-tax Contribution Equation
$66,000 is the IRS limit in 2023MinusPre-tax and/or Roth Contribution$22,500 (+$7,500 if over 50 years)MinusEmployer Contribution(Discretionary and/or Non-Discretionary)EqualsPotential After-tax Contribution Allowable

In-Service After-tax Voluntary Conversion to a Roth IRA

Generally, when completing a 401(k) after-tax voluntary conversion to a Roth IRA, the conversion principal from a direct after-tax rollover is deposited into a Roth IRA, and earnings are rolled over into a Traditional IRA. However, earnings can also be converted to a Roth and tax paid.

When money is converted from the after-tax voluntary bucket of a 401(k) to a Roth IRA over a series of years, employees can build a significant amount of converted principal available to be accessed in early retirement that would otherwise likely be locked up until age 59.5. Though the conversion basis can be accessed, if conversion earnings are distributed before 59.5 and/or five years, whichever is longer, the gains are taxed and penalized.

Why can’t I access these converted funds in my Roth 401(k)? *

In most cases, pre-retirement pro-rata distribution rules apply to unqualified early distributions from a 401(k). If you have a Roth 401(k) and take an early distribution, it will most likely be a mix of taxable (with penalty) and nontaxable funds.

After-tax conversions work in Roth IRAs because distribution rules are ordered as follows:

  1. Contributions
  2. Taxable Conversions
  3. After-tax Conversions
  4. Earnings

How and when can I access money from a Roth IRA without penalty?

  • Always access your contributions penalty-free
  • Taxable conversions are penalty-free five years after the conversion
  • You can access the nontaxable conversion principal penalty-free at any time
  • Access earnings free and clear after 59.5 or five years, whichever is longer

Let’s say you are 30 years old and looking to retire before the age of 50. Having money in a retirement account that is accessible, without penalty, is important regardless of age. Each year for 10 years, you make after-tax contributions to your 401(k)  of $10,000, which grow to $11,000 before you request an in-service conversion rollover of this money into a Roth IRA. You invest the Roth IRA for growth, and it earns another $10,000. That growth will be tax and penalty-free as long as you wait until age 59.5 and at least five years to withdraw the earnings. However, the basis that you have converted over the years from your after-tax voluntary 401(k) account can be taken out without penalty or tax, regardless of age.

Here is what happens if you decide to withdraw the entire amount prior to age 59.5:

401(k) Contributions and Gains
After-tax contributions to 401(k) – $100,000
Total gains realized on after-tax contributions – $10,000

Backdoor Conversion to Roth IRA
Basis converted to Roth IRA – $100,000
Growth converted to Roth IRA and taxed upon conversion – $10,000

Withdrawal from Roth IRA prior to age 59.5
Contributions (tax and penalty-free) – $0
Taxable Conversion (10% penalty if held less than 5 years) – $10,000
After-Tax Conversion (tax and penalty free) – $100,000
Gains realized after conversion to Roth IRA (taxable and 10% penalty) – $10,000

Important Notes

* There may be plan-specific rules. Please check with the administrator for your work retirement.

* There are always exceptions to the rules, so before conversion, please seek advice from a tax expert that will help you understand the conversion tax implications.

* There are different distribution rules for after-tax contributions made before 1987. Consult your tax advisor for more information.

* Conversions may affect net unrealized appreciation (NUA) treatment on employer’s stock positions.