The IRS finally gave up after years of fighting that after-tax 401(k) dollars cannot be rolled into a Roth conversion. Most people simply put money into their 401(k) pre-tax–up to the annual employee limit. However, some plans allow employees to make contributions above the annual deductible limit on an after-tax basis. The employee didn’t get the tax deduction, but their dollars grew tax-deferred, which was a popular strategy with high income employees.
With the introduction of the Roth IRA, many after-tax 401(k) participants sought to rollover their pre-tax dollars to a Traditional IRA and their after-tax dollars to a Roth Conversion. This became even more popular when the Pension Protection Act of 2006 allowed for direct Roth conversions from 401(k) plans.
Up until IRS Notice 2014-54, taxpayers attempting such conversions were at risk of creating a huge tax headache for themselves and their advisors. The IRS had taken the position that these conversions should taxed on a “pro-rata” basis. If you attempted the after-tax Roth conversion, you typically got a nastigram from the IRS saying you can’t do that and oh by the way you owe us for back taxes and penalties.
While the new rules don’t go into effect until 2015, the IRS said it is reasonable to use the strategy going forward. If you’re maxing out your 401(k) now, you may want to start using this strategy if your employer allows after-tax contributions.