Although 401(k) plans are known for their tax-deferral benefits, some allow after-tax contributions. When you retire or change jobs, you can roll over this after-tax 401(k) money to a Roth IRA. This is advantageous, as money in a Roth accumulates interest, dividends, and capital gains that are tax-free.
There are some rules you need to follow to roll over your after-tax 401(k) funds correctly, though. Here are some common concerns and questions about how this type of rollover works.
- In 2014, the IRS ruled that you can roll after-tax contributions to a 401(k) into a Roth IRA.
- You must roll over a proportional amount of pre-tax funds along with your after-tax rollover amount.
- You have 60 days to deposit rollover funds into the appropriate account; otherwise, it’s considered taxable.
IRS Rules About Rolling After-Tax Funds to a Roth
For many years, the financial planning and tax community was not sure if after-tax funds in a company plan could legally be rolled into a Roth IRA. In September 2014, an IRS ruling clarified this, and the answer is a definitive "Yes." As a result, you are permitted to roll the after-tax contributions from a qualified company retirement plan to a Roth IRA.
The catch, however, is that you must also roll over pre-tax 401(k) contributions in a proportional amount based on what you have put into your fund. So, for example, if your 401(k) has $200,000 in it, and 10% of that includes after-tax contributions, your rollover distributions will always be 10% after-tax and 90% pre-tax.
The only way to roll all of your after-tax contributions into a Roth IRA is to simultaneously roll all of your pre-tax contributions into a traditional IRA or other eligible tax-deferred account.
To facilitate the rollover of after-tax 401(k) funds to a Roth IRA, your plan administrator will cut two checks—one for the after-tax contributions and one for the pre-tax money. You can direct the after-tax contributions to go right toward a Roth IRA account while the pre-tax money gets rolled into a traditional IRA. You would designate the appropriate account for each respective contribution type on your 401(k) distribution paperwork.
What if You Deposit the Funds in the Wrong Account?
When you receive a rollover check, you have 60 days to deposit it into the appropriate account. If you miss the 60-day deadline, your rollover will not count as a rollover and will thus become taxable.
Exceptions to the 60 day rollover time frame are hard to come by unless your financial services company made a gross error. That's why it's important to have a clear plan for where your rollover funds are going and to make sure your financial advisor or plan administrator knows exactly where to put the money.
Avoiding Rollover Mistakes
At retirement, make sure you follow all of the rollover rules so that you won't encounter any unpleasant tax surprises. Read all paperwork carefully before you submit it to your plan administrator, and double-check account numbers before you make deposits.
You can look at your most recent 401(k) statement to see about how much should be in after-tax funds. Make sure the check amount you are depositing to your Roth is approximately that same amount. (It likely won't be exactly the same amount as on your statement, because funds fluctuate daily as the investments change in value.)
Other Rollover Options
If you're retiring or separating from a company, you have other options besides a Roth IRA. You could roll the funds into a traditional IRA, move them into a new company's 401(k) plan, or leave them where they are. Since 401(k) plans are portable, you don't have to do anything with the money until you're ready. The 60-day clock doesn't start until you begin the transfer process.
For that reason, take your time, talk to a financial advisor, figure out the best way to roll over the funds, and then start the process. There's no need to do it as soon as you separate from the company, especially if you have a high balance.