If your 401(k) has different types of dollars, it’s crucial to know which “buckets” to roll them into and understand the impact of your decisions. 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, that 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. All of the dollars could be rolled to a traditional IRA or 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 into a Roth IRA (tax-free conversion) and the $20,000 into a traditional IRA. Another option is for Robert to roll the entire $70,000 into 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 into a traditional IRA. Yes, the $20,000 would remain tax-deferred. However, the $50,000 would then be basis on 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.
By Andy Ives, CFP®, AIF®
IRA Analyst
