By Ian Berger, JD
The October 19, 2020 Slott Report article, “Don’t Overlook After-Tax Contributions!,” explained how after-tax contributions in company plans work and discussed the dollar limits on them. This article will explain how distributions of after-tax contributions are taxed and can be rolled over separately.
If you have both pre-tax deferrals and after-tax contributions in your 401(k), you can’t just take out your after-tax funds to avoid paying taxes on the withdrawal. Instead, a pro-rata rule treats part of your distribution as taxable.
If your plan separately accounts for after-tax contributions and earnings on those contributions, the pro-rata rule applies only to that separate account. In that case, the portion of each withdrawal that is taxable is the ratio of the earnings to the value of the entire separate account (after-tax contributions plus earnings). Most plans use separate accounting but check with the plan administrator or your HR rep if you’re not sure.
Example 1: Jamir participates in a 401(k) plan that separately accounts for after-tax contributions and earnings. He has $100,000 in after-tax contributions and $25,000 in earnings on those contributions. Jamir withdrawals $40,000 from that account. The pro-rata rule applies just to that separate account. So, 20% ($25,000/$125,000) of the withdrawal, or $8,000, is taxable. The remaining $32,000 comes out tax-free.
By contrast, if after-tax contributions (and earnings) aren’t separately accounted for, then the pro-rata rule applies to your entire plan account. That means Uncle Sam gets a bigger share of any withdrawal – the ratio of the value of the entire account other than after-tax contributions to the value of the entire account.
Example 2: Assume Jamir’s 401(k) plan doesn’t have separate accounts. Besides his $100,000 in after-tax contributions, Jamir also has $150,000 in pre-tax deferrals, employer contributions and overall earnings, for a total account balance of $250,000. Jamir again makes a $40,000 withdrawal. This time, the pro-rata rule applies to his entire 401(k) account. So, he must pay taxes on 60% ($150,000/$250,000) of the withdrawal, or $24,000. Only $16,000 escapes tax.
IRS guidance from 2014 now makes it possible for you to simultaneously roll over the after-tax portion of your plan distribution to a Roth IRA and roll over the pre-tax portion to a traditional IRA. This can be a big tax-saver. However, the IRS guidance doesn’t change the pro-rata rule to determine which part of a distribution is taxable and which part isn’t. It also doesn’t apply to IRAs – including SEP and SIMPLE IRAs.
Example 3: In Example 1, Jamir can roll over the $32,000 after-tax portion to a Roth IRA and the $8,000 pre-tax portion to a traditional IRA. The $32,000 would be converted tax-free to a Roth IRA, and any Roth IRA earnings could be withdrawn tax-free down the road if they are part of a qualified distribution.
Since these rules are complicated, be sure to speak with a financial advisor when faced with a distribution of after-tax monies.