A planning opportunity for US 401(k) distributions

There is much focus around the years spent saving for retirement and the ways to accumulate assets in a tax-efficient manner. However, there tends to be less focus around how to distribute retirement assets efficiently. There are the usual rules of thumb: draw down taxable assets first, then tax deferred, then tax exempt. But, there can also be unique opportunities to create buckets of pre-tax and post-tax assets within tax deferred and tax exempt accounts to help facilitate drawdown.

One unique opportunity is the results from a clarification about the distribution treatment of 401(k) assets. Back in 2014, the IRS issued a Notice indicating that it will allow plan participants who have after-tax contribution money in their 401k accounts to convert this money to a Roth IRA upon separation of service from their employer, without being subject to the pro-rata tax rules that normally apply to conversions that occur from Traditional IRAs to Roth IRAs.  The conversion must be made at the same time as any direct rollover of other 401k money (i.e. a total distribution rollover as opposed to any partial distributions). In essence, employees now can more easily roll over after-tax contributions into a Roth IRA when they retire or leave their company. Why is this potentially so valuable? Individuals in this position have the ability to move assets directly into a Roth IRA without creating a current tax year burden and at the same time secure a bucket of money that would be available to grow tax exempt for years to come. Not only can individuals benefit from the roll up of tax exempt growth, Roth IRAs are also not subject to the Required Minimum Distribution rules as Traditional IRAs and 401ks are. This can provide even greater benefits for those people who have a legacy goal of passing the assets on to heirs.

The IRS ruling and the ability to segment the taxable nature and sourcing of the 401(k) assets may provide a valuable planning opportunity to Americans who have ever contributed to a US 401(k) whilst living and working abroad. When the opportunity arises to make contributions to a US 401(k) whilst living and working abroad, the employee contributions (and the contributions of the employer) made during the time related to overseas service would be considered foreign source for US tax purposes. Having foreign source dollars within a 401(k) may prove valuable for anyone who has excess foreign tax credits available for use on their US tax returns. At distribution, if any portion of the distribution is considered foreign source then available foreign tax credits may be used to offset associated US tax.

This means that it may be possible for some people to move the portion of the 401(k) account that represents foreign sourced dollars directly into a Roth IRA with the remaining assets moved to a Traditional IRA thereby preserving the tax deferral until distribution. Being able to bypass the Traditional IRA effectively prevents the pro-rata rule from applying thus potentially maximising the amount of money able to be converted to the Roth while minimising the amount of associated tax that would apply. It is important to note that any opportunity is highly dependent on individual circumstances. Any individual considering the appropriate distribution strategy should seek tax advice from a qualified tax professional to ensure that all necessary steps are taken and not mistakenly overlooked.

For more wealth planning tips and tidbits from MASECO read our 39 Steps to Smart Living in the UK.

Risk Warnings and Important Information
The above article does not take into account the specific goals or requirements of individual users. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.

MASECO LLP trading as MASECO Private Wealth is authorised and regulated by the Financial Conduct Authority, the Financial Conduct Authority does not regulate tax advice.  MASECO Private Wealth is not a tax specialist. We strongly recommend that every client seeks their own tax advice prior to acting on any of the strategies described in this document.

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