Many folks have questions about their 401(k) dollars. How to access them and how to convert them moving forward. It can be confusing, but the CFS* wealth management advisors at Elevations can help you navigate your choices like the example below.
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 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?
In the past, many trustees allowed you to do just that. However, in recent years, the IRS had suggested that you could not achieve this result with multiple direct rollovers. According to the IRS, each rollover would have to carry with it a pro-rata amount of pre-tax and after-tax dollars. The legal basis for this position, however, was not entirely clear.
IRS Notice 2014-54
Thankfully, in Notice 2014-54 (and related proposed regulations), the IRS has backed away from its prior position. The Notice makes it clear that you can split a distribution from your 401(k) plan. Then you can directly roll over only 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 also applies to 403(b) and 457(b) plans.
When applying Notice 2014-54, it’s essential to understand some basic rules (also outlined in the Notice). First, you have to know how to calculate the taxable portion of your distribution. Calculating the taxable portion is easy if you receive a total distribution — the nontaxable part is your after-tax contributions, and the taxable portion is the balance of your account. However, if you’re receiving less than a total distribution, you have to perform a pro-rata calculation.
This calculation is best understood using an example. 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. What this means is that you can’t, for example, request a distribution of $40,000 consisting only of your after-tax dollars. The Notice requires that 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).
Taking this example a step further, 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.
It’s these new rules that allow you to accomplish your goal of rolling over only the after-tax portion of your 401(k) plan distribution into a Roth IRA. These rules make it clear that you can instruct the 401(k) plan trustee to transfer only your pre-tax dollars. From our example, this would mean — $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.
Make sure you understand all the pros and cons when evaluating whether to initiate a rollover from an employer plan to an IRA. Always be sure to do the following:
- Ask about possible surrender charges that may be imposed by your employer plan or new surrender charges that your IRA may impose.
- Compare investment fees and expenses charged by your IRA (and investment funds) with those charged by your employer plan (if any).
- Understand any accumulated rights or guarantees that you may be giving up by transferring funds out of your employer plan.
For more information on 401(k) and IRA options and to schedule your, no-obligation consultation, please contact our qualified CFS* Wealth Management advisors today.
**Non-deposit investment products and services are offered through CUSO Financial Services, L.P. (“CFS”), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. Elevations Credit Union has contracted with CFS to make non-deposit investment products and services available to credit union members.
CUSO Financial Services, L.P. (CFS) does not provide tax or legal advice. For such guidance, please consult your tax and/or legal advisor.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2019