Posted by Jorge Guerrero, CPA
When taxpayers mix pre-tax and after-tax contributions in the same retirement account such as a 401(k) or other defined contribution retirement plan, withdraws and rollovers can have unintended tax consequences if not properly planned. The IRS requires distributions made from a retirement account to be made on a pro rata share basis. They cannot be made from just one “pool”. For example, Kay has a 401(k) account with a balance of $100,000. It contains of $75,000 of pre-tax contributions, which includes earnings from the after-tax portion, and $25,000 of after-tax contributions. If Kay makes a partial rollover or distribution, 25% of it will include after-tax money.
If Kay is looking to separate pre-tax and after-tax holdings in her retirement account, the IRS recommends that she make a full distribution from the account to multiple destinations. This is advantageous because the IRS treats rollovers to multiple destinations as a single rollover. Using this feature allows a taxpayer to move the pre-taxable portion to a traditional IRA while moving the after-tax portion to a Roth IRA at the same time. A distribution of after-tax funds may also be taken during this process. Using our example above, Kay could rollover the $75,000 of pre-tax contributions to a traditional IRA, $20,000 of after-tax contributions to a Roth IRA, and pocket the remaining $5,000 of after-tax contributions. Since earnings on after-tax contributions are considered pre-tax funds they must be rolled over into a “pre-tax account” to avoid penalties.
For more information on making distributions from retirement accounts please contact one of our tax professionals.