How Plan After-Tax Contributions Are Taxed When Converted
If you have made after-tax contributions to your plan, any earnings on those contributions are taxable when distributed to you. If you have earnings, you can’t just take out the after-tax contributions to avoid paying taxes on a withdrawal. Instead, a pro-rata rule treats part of your distribution as taxable.
Most 401(k)s have a separate account that contains only after-tax contributions (not taxable) and earnings (taxable). If your plan does separate accounting, then only that account is considered in doing the pro-rata calculation. (Neither pre-tax accounts nor Roth accounts within your 401(k) are considered for this calculation.) The portion of each withdrawal taxable to you is the ratio of earnings in the after-tax account to the value of the entire separate account. If you’re not sure whether your plan uses separate accounting, check with the plan administrator or your HR rep.
Example: Mei participates in a 401(k) plan that separately accounts for after-tax contributions and their earnings. She has $100,000 in contributions and $25,000 in earnings in that account. Mei wants to do an in-plan conversion to have $40,000 of that account transferred to her Roth account within the plan. Mei cannot just have all $40,000 come from non-taxable after-tax contributions. Instead, 20% ($25,000/$125,000) of the withdrawal, or $8,000, must come from taxable earnings. The remaining $32,000 comes from after-tax contributions and is tax-free.
Conversions for 401(k) Accounts
By contrast, if Mei’s plan doesn’t have separate accounts, her pre-tax 401(k) accounts (e.g., elective deferrals and employer contributions) must be considered in calculating how much of the $40,000 conversion is taxable. That will require her to pay much higher taxes on the conversion.
The same tax analysis would apply if you are using the mega backdoor Roth IRA strategy to move after-tax contributions to a Roth IRA (instead of to your Roth 401(k) account through an in-plan conversion) while you’re working. Again, if your plan has separate accounting, only that after-tax account comes into play when calculating how much of the Roth IRA conversion is taxable.
You can avoid any immediate taxes on a Roth conversion by doing a split rollover of your after-tax and pre-tax 401(k) accounts. You would roll over your after-tax funds to a Roth IRA and your pre-tax funds (including earnings on after-tax contributions) to a traditional IRA. The after-tax funds would be converted tax-free to a Roth IRA, and any subsequent earnings could be withdrawn from the Roth IRA tax-free down the road. However, this split rollover is not available until age 59½ if you’re still working, and depending on the terms of your plan, may not be available until after you leave employment.
Since these rules are complicated, you should contact a knowledgeable financial advisor to discuss how to handle your after-tax plan contributions.
By Ian Berger, JD
IRA Analyst
Ed Slott and Company, LLC
Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.