Workplace retirement plans – like a 401(k) – can hold different types of dollars. Typically, a 401(k) will have a pre-tax bucket and a Roth bucket. Occasionally, a plan will have a third bucket to hold after-tax (non-Roth) money. When it comes time to roll all these plan dollars to an IRA, where should (and where can) the different dollars go?
Pre-Tax. Pre-tax salary 401(k) deferrals, employer matches, and any subsequent earnings on these dollars within the plan are typically rolled over to a traditional IRA. By rolling to a traditional IRA, the funds retain their tax-deferred status. Once in the traditional IRA, the former plan dollars and any future earnings avoid taxation until they are distributed.
But rolling pre-tax plan dollars to a traditional IRA is not required. A plan participant could roll all or a portion of his pre-tax 401(k) dollars directly to a Roth IRA, bypassing a traditional IRA completely. This transaction qualifies as a valid Roth conversion. (Some refer to this as a “mid-air conversion.”) The pre-tax plan dollars will then be taxable for the year of the rollover.
Roth. Roth 401(k) salary deferrals and earnings can only be rolled to a Roth IRA. Assuming the proper 5-year clocks and age 59 ½ rules are met, all Roth earnings from the plan (as well as future earnings within the Roth IRA) will be tax-free. Do NOT make the mistake of rolling Roth plan dollars to a traditional IRA. That is a “no-go zone.”
After-Tax (Non-Roth). After-tax 401(k) contributions are not available in every plan. But if they are, after-tax plan contributions are just that – after-tax dollars. However, these are not Roth funds. Meaning, earnings on these after-tax dollars are taxable. If your plan includes a bucket for after-tax dollars, understanding the implications of a future rollover is imperative.
Most 401(k) plans can separate after-tax contributions from their earnings. The after-tax contributions are typically rolled over to a Roth IRA. This qualifies as a tax-free conversion. The segregated earnings on the after-tax dollars are most often rolled to a traditional IRA. This makes sense as those after-tax earnings can then retain their tax-deferred status within the traditional IRA.
But routing the after-tax contributions to a Roth IRA via rollover and the after-tax earnings to a traditional IRA is not required. In fact, ALL of the dollars could be rolled to a traditional IRA or to a Roth, and there are consequences for each action.
Example: Robert has $50,000 of after-tax (non-Roth) contributions in his 401(k), and there are $20,000 of earnings associated with those contributions ($70,000 total). If Robert’s plan provider splits the money, a common recommendation is to roll the $50,000 to a Roth IRA (tax-free conversion) and the $20,000 to a traditional IRA. Another option is for Robert to roll the entire $70,000 to a Roth IRA. Since the $20,000 of earnings are pre-tax, those dollars would be taxable. A far-less-pleasant third option is to roll all $70,000 to a traditional IRA. Yes, the $20,000 would remain tax-deferred. However, the $50,000 would then be basis in the traditional IRA and must be accounted for. Meaning, the pro-rata rule is now introduced to all future distributions and conversions from Robert’s traditional IRA.
If you have different types of dollars within your 401(k), it is vital to know where each “bucket” should be sent via rollover and the ramifications of your decisions.
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