New IRS Rule Can Make Big Difference in 401(k) Contributions

People who’ve made both pretax and after-tax contributions to their workplace retirement plan can now easily separate them when rolling them over to traditional and Roth IRAs, thanks to a recent IRS ruling.
Eric Meermann
Published: April 01, 2016

Separating Pretax, After-Tax Contributions in Rollovers Lets People Put More in Roth IRA—Regardless of Income

People who’ve made both pretax and after-tax contributions to their workplace retirement plan can now easily separate them when rolling them over to traditional and Roth IRAs, thanks to a recent IRS ruling.

It can make a big difference for some. A big advantage is that after-tax contributions to a 401(k) or 403(b) plan now can be rolled over directly into a Roth IRA. Pretax contributions can be rolled over into a traditional IRA, where they’ll grow tax-deferred.

Until recently, an employee whose retirement plan included both pretax and after-tax contributions faced a confusing situation when retiring or changing jobs. Each distribution had to include a prorated share of after-tax and pretax contributions. 

When funds were sent to a Roth IRA, the account holder had to pay prorated taxes on the pretax portion of the transfer. When the funds were sent to a traditional IRA, investment earnings produced by after-tax dollars were simply tax-deferred. They would eventually be taxed at ordinary income rates, instead of at lower capital gains rates that would apply if the after-tax funds were not rolled over and simply invested in a taxable account.  

Under its September 18, 2004 notice, the IRS now lets you separate blocks of contributions when choosing where to send them, as long as the distributions are made at the same time. Therefore, when you roll over your 401(k) or other qualified retirement plan, you can avoid rolling any portion of your after-tax contributions into a traditional IRA, where any growth will be taxed at ordinary income rates when distributed.

Because you can now direct rollovers to different accounts for pretax and after-tax contributions, you can match the tax character of the contributions to the retirement account that treats them most favorably.

Let’s say Charles has $250,000 in his employer’s 401(k) plan, which does not offer a Roth option. He originally made $75,000 of pretax contributions and $50,000 of after-tax contributions. He retires and rolls over his assets to a traditional IRA and a Roth IRA . The basis in the 401(k) stays equal to the amount of after-tax contributions made: $50,000.

Now, Charles can allocate $200,000 of pretax money to his traditional IRA and $50,000 of after-tax money to his Roth IRA—even if his income is too high to otherwise permit a Roth contribution.



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