For years the IRS held strong: When rolling over 401(k) funds, after-tax and pre-tax funds are distributed pro-rata. However, with the recent issuance of IRS Notice 2014-54, the rules have changed.

Historically, for those who maxed out their tax-deferred growth options, saving money in an after-tax 401(k) plan was not a great strategy. The IRS’ stance on pro-rata distributions made it impossible to convert after-tax funds in a 401(k) to a Roth IRA and pre-tax funds to a traditional IRA in tax-free transactions. Now, the IRS has reversed its prior position and taxpayers who wish to roll over their 401(k) funds may allocate the after-tax portion to a Roth IRA.

Technically the rules do not apply until 2015, but the IRS acknowledged that it would reasonably respect the ruling for this year, giving taxpayers the go-ahead for 2014.

Consider the following example for 2014, if your 401(k) allows for after-tax contributions:

  • If you are over 50, you can contribute $23,000 to your 401(k).
  • Assume your company matches 50 cents on the dollar. This makes your total contribution $34,500 ($23,000 + $11,500).
  • The combined limit for 2014 is $57,500, so this leaves you room to contribute an additional $23,000 after tax, which can eventually be converted to a Roth IRA.

Bottom line – This ruling is huge for high earners, previously prevented from contributing to Roth IRAs because of income limits. In addition, the savings possibilities for those that are able to contribute is far higher than the typical $6,500 annual limit, which takes a long time to build.