Converting your after-tax 401(k) dollars to a Roth IRA

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Here’s the dilemma: You have a traditional 401(k) that contains both after-tax and pre-tax dollars. You’d like to receive a distribution from the plan and convert only the after-tax dollars to a Roth IRA. By rolling over/converting only the after-tax dollars to a Roth IRA, you hope to avoid paying any income tax on the conversion.

For example, let’s say your 401(k) plan distribution is $10,000, consisting of $8,000 of pre-tax dollars and $2,000 of after-tax dollars. Can you simply instruct the trustee to directly roll the $8,000 of pre-tax dollars to a traditional IRA and the remaining $2,000 of after-tax dollars to a Roth IRA?

IRS Notice 2014-54
Notice 2014-54 makes it clear you can split a distribution from your 401(k) plan and directly roll over the pre-tax dollars to a traditional IRA (with no current tax liability) and only the after-tax dollars to a Roth IRA (with no conversion tax). The IRS guidance, which took effect January 1, 2015, also applies to 403(b) and 457(b) plans.

When applying Notice 2014-54, it’s important to understand some basic rules. First, you have to understand how to calculate the taxable portion of your distribution. This is easy if you receive a total distribution — the nontaxable portion is your after-tax contributions, and the taxable portion is the balance of your account. But if you’re receiving less than a total distribution, you have to perform a pro-rata calculation.

Assume your 401(k) account is $100,000, consisting of $60,000 (six tenths) of pre-tax dollars and $40,000 (four tenths) of after-tax dollars. You request a $40,000 distribution. Of this $40,000, six tenths, or $24,000, will be taxable pre-tax dollars, and four tenths, or $16,000, will be nontaxable after-tax dollars. This means you can’t, for example, simply request a distribution of $40,000 consisting only of your after-tax dollars. The Notice requires you treat all distributions you receive at the same time as a single distribution when you perform this pro-rata calculation (even if you subsequently roll those distributions into separate IRAs).

Could you now direct the trustee to directly transfer the $16,000 of after-tax dollars to a Roth IRA (with no conversion tax) and send the remaining $24,000 to you in a taxable distribution? The answer is no, and this leads to a second basic rule described in the Notice: Any rollovers you make from a 401(k) plan distribution are deemed to come first from your pre-tax dollars, and then, only after these dollars are fully used up, from your after-tax dollars. If you’re rolling your distribution over into several different accounts, you get to decide which retirement vehicle receives your pre-tax dollars first.

These rules allow you to accomplish your goal of rolling over only the after-tax portion of your 401(k) plan distribution into a Roth IRA. Going back to our example, these rules make it clear you can instruct the 401(k) plan trustee to transfer only your pre-tax dollars — $24,000 — to your traditional IRA, leaving the remaining $16,000 — all after-tax dollars — to be rolled over to your Roth IRA in a tax-free conversion.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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