Be Aware of this IRA Rollover Issue

October 5, 2011

If you’ve been contributing to your 401(k) for some time you may have after-tax contributions to your plan. Typically these were excess contributions that were made over the pre-tax limits, however I have come across cases where employees mistakenly placed all of their contributions into an after-tax account.

When rolling over your 401(k) your plan sponsor may send the amounts contributed after-tax as a separate check from your pre-tax and employer contributions. And while all of the money can be rolled over into an IRA, many in the past recommended the after-tax check simply be cashed. This way there is no need to report the fact that you now have basis in your IRA accounts, and be required to pro-rate that tax-free return of your after-tax contributions over each and every future withdrawal.

However IRS Notice 2009-68 clarified that when cashing the after-tax check the pro-rata rule is applied as though the check is a distribution – meaning even though the check appears to be for the amount of the after-tax contributions, it is actually a distribution that is part return of after-tax dollars, part taxable withdrawal.

An example: If you had distributed $600,000 from a 401(k), $200,000 being after-tax contributions that were not rolled over into an IRA, and $400,000 that was; the $200,000 after-tax money will be treated as 1/3 return of after-tax, and 2/3 taxable distribution. You have after-tax basis in your IRA that needs to be reported to the IRS on your income tax returns.

An option to avoid this is to rollover the entire amount to a separate IRA. Alternatively, by performing a 60-day rollover you may separate the pre-tax and after-tax amounts, as the amounts rolled to the IRA would be considered pre-tax first. Note that this option will require the plan sponsor to withhold 20% that would have to be available to complete the pre-tax rollover.

 

The preceding blog was originally published by Forbes. To view the original blog please visit our blog at Forbes. http://www.forbes.com/sites/feeonlyplanner/

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