Workplace retirement plans like 401(k)s offer some tax benefits for your retirement savings. The tax benefit you receive depends on the type of contributions you make. It's important to understand the way your contributions are taxed so you can make informed decisions about what to do with your money.
There are 3 types of contributions a participant can make to a workplace retirement plan: pre-tax (or traditional) contributions, Roth contributions, and after-tax contributions.
Taxes on earnings from after-tax contributions
After-tax contributions to a 401(k) (or other workplace retirement plan) get a different tax treatment than their earnings. Since you've already paid taxes on the contributions, those withdrawals are tax-free in retirement. But the IRS considers the earnings to be pre-tax—so they would be treated as pre-tax and you would owe income tax when you take them out of the account.
Earnings in Roth IRAs, however, aren't subject to income tax as long as all withdrawals from the account are qualified withdrawals. So rolling after-tax money from a workplace plan to a Roth IRA means you can avoid taxes on any future earnings.
Rolling over after-tax money to a Roth IRA
If you have after-tax money in your traditional 401(k), 403(b), or other workplace retirement savings account, you can roll it over to a Roth IRA without paying taxes, as long as certain rules are met. (Note: Your plan's terms will determine when and how money is distributable. Please review your plan document or summary plan description for more information about disbursements from the plan.)
According to IRS guidance, you can roll after-tax money to a Roth IRA and pre-tax money to a traditional IRA and avoid creating taxable income. As with any decisions with potential tax implications, always consult a tax advisor to decide if it’s the right move for you. The IRS allows for a few different scenarios—but not all may be allowed by your plan.
In the most straightforward scenario, the entire account balance would be rolled out of the workplace plan, sending after-tax contributions to a Roth IRA and pre-tax contributions and earnings to a traditional IRA.
The IRS allows plan participants to take partial withdrawals, including those that are from a single source balance. The catch is that your plan is not obligated to permit partial distributions and also may not track the sources of each participant's balance.
If the plan allows partial withdrawals and does track each source balance separately, one could take a rollover of just the after-tax source balance, which includes both the after-tax contributions and all of the associated earnings. Again, the after-tax balance would go to a Roth IRA while earnings would go to a traditional IRA.
In that scenario, one could also choose to roll out only a portion of the after-tax balance. In that case, the rollover must be split proportionally between after-tax contributions and earnings relative to the levels of each in the plan.
Important note: Any partial withdrawals may affect eligibility for net unrealized appreciation treatment on appreciated employer stock held in the plan.
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Contributions made before 1987 are treated differently than those made after 1987. Unlike post-1986 employee contributions, pre-1987 employee contributions may be distributed without taking a taxable disbursement of the associated earnings. If you have contributions from 1986 or before, consult your tax advisor for more information.
Other potential benefits of rolling after-tax contributions to a Roth IRA
Investment choices. A Roth IRA may provide more investment choices than are typically available in an employer's plan, although an employer's plan may also offer institutionally priced investments and/or customized plan options not available in an IRA.
Required distributions. There are no required minimum distributions (RMDs), from a Roth IRA during your lifetime. Once you reach age 70½, however, you will need to start taking distributions from a 401(k) including those contributions and earnings recordkept as Roth contributions to the plan, unless you are still working at the company.
Some employers offer a Roth 401(k) option and also allow participants to convert after-tax contributions into an in-plan Roth account, so check with your employer to see if it is an option. In some cases, it may make sense to roll over your after-tax contributions to a Roth inside your plan than outside.
Flexibility. Once the money is in a Roth IRA, you may have greater flexibility in terms of withdrawals before retirement. Unlike employer-sponsored retirement plans, Roth IRAs allow (within limits) for penalty-free withdrawals for a first-time home purchase or qualified education expenses like going to graduate school.* After certain requirements are met, converted balances within Roth IRAs may be withdrawn without taxes or penalties for other purposes as well. Finally, Roth IRAs are also not subject to various restrictions that plan sponsors sometimes place on workplace plans.
Here’s how it works
Let's look at 2 hypothetical examples of a 401(k) rollover to a Roth IRA.
In the first, let's assume Andrew is age 60, retired, and has $1 million in his 401(k): $800,000, or 80%, is pre-tax; and $200,000, or 20%, is after-tax contributions. We'll also assume that while Andrew’s plan does allow partial withdrawals, it does not track source balances separately. So while only part of the $800,000 in pre-tax balances is attributable to earnings on Andrew's after-tax contributions (the remainder being some combination of pre-tax contributions, earnings, and matching) the entire pre-tax balance, regardless of source, is treated as a single lump sum. Andrew wants to roll over $100,000 from his 401(k) to IRAs and leave the remainder where it is.
If he rolls over $80,000 to a traditional IRA and $20,000 to a Roth IRA, he will have no federal income tax liability. That's because the rollover to the traditional IRA is equal to the proportion (80%) of pre-tax money in the 401(k). The rollover of after-tax amounts to a Roth IRA are tax-free.
What if Andrew wanted to roll over $100,000 entirely into a Roth IRA? He could do that, but in this case, $80,000 would be considered a taxable Roth conversion, because 80% of his 401(k) balance is pre-tax money.
Now let's consider a second hypothetical example: Everything is the same except that we'll assume Andrew's plan does track source balances separately, so Andrew can withdraw just from his after-tax source balance. Also, let's assume that of the $800,000 in total pre-tax balances, $100,000 is earnings attributable to the after-tax contributions. Another way to look at it is that Andrew has made $200,000 in post-1986 after-tax contributions to the plan with $100,000 in pre-tax earnings attributable to the contributions.
Instead of considering the entire account, and treating the $100,000 withdrawal as 80% pre-tax and 20% after-tax, Andrew would make a withdrawal from the after-tax source balance only, and that would be 66.6% after-tax and 33.3% pre-tax. This is because the after-tax source balance is composed of $200,000 in after-tax contributions and $100,000 in earnings, for a total of $300,000, so the $200,000 in after-tax contributions represents two-thirds of the total and the earnings represent the remaining one-third.
When planning to roll over after-tax and pre-tax contributions, be sure to let the plan administrator know. That can help ensure that the distributions are reported to the IRS appropriately.
Weigh all options
Deciding whether to roll over your 401(k) isn't necessarily a straightforward decision. This is why we suggest that investors carefully assess their situation, consider all available options and the applicable fees and features of each before moving retirement assets, and check with a tax advisor to help make an informed decision.
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