Michael Kitces has written about Notice 2014-54. His article begins as follows:
While most people who contribute to a traditional 401(k) plan receive a tax deduction for their contributions, some 401(k) plans allow participants to make additional after-tax contributions over and above the deductible thresholds, up to the annual defined contribution plan limit. For those who have already maxxed out other available tax-deferred growth options, the after-tax 401(k) plan was better than nothing.
Upon retirement, though, many retirees sought to take advantage of rules that allow them to roll over their pre-tax 401(k) assets and take their after-tax contributions back, taking the two checks that the plan administrator provides them but rolling them both over – the pre-tax portion to a traditional IRA, and the after-tax to a Roth IRA in an effective tax-free Roth conversion. And the strategy only become more popular after the Pension Protection Act of 2006, which further opened the door to direct Roth conversions from 401(k) plans, and therefore the potential to directly convert “just” the after-tax check.
After years of fighting the strategy and claiming that the pro-rata rule should still apply to such conversions, the IRS has issued IRS Notice 2014-54, reversing its prior position and acquiescing to taxpayers who wish to roll over their 401(k) funds and proactively allocate their pre-tax amounts to the traditional IRA and the after-tax portion to a (tax-free) Roth conversion. While the rules are technically not applicable until 2015, the IRS has even acknowledged that it would be “reasonable” to rely on the approach now, making an open season for the strategy to split out after-tax 401(k) contributions for conversion effectively immediately.
In fact, it appears that the new IRS rules are so open in this regard, that they not only permit the free conversion of after-tax 401(k) contributions into a subsequent Roth IRA, but the availability of this conversion makes it more appealing than ever to make after-tax contributions into a 401(k) plan in the first place (at least after first obtaining the employer 401(k) match and maxxing out available pre-tax or Roth contribution limits). Will the new rules lead to a resurgence of higher-income individuals making after-tax contributions to a 401(k) plan, after maxxing out available alternatives, for the sole purpose of preparing to complete a future tax-free Roth conversion of the contributions down the road?