Some employer-sponsored 401(k) retirement plans allow participants to contribute more than the amount eligible for tax-deferral. Although income tax is paid on the additional contribution, interest earned is not taxed until withdrawn. Starting in 2015, individuals with both pretax and after-tax 401(k) contributions have increased incentive to roll their 401(k) over to an IRA.
Many 401(k) account holders choose to roll their funds over to an individual retirement account because the IRA has a wider array of investment choices. The ideal rollover scenario is to continue deferring income tax on the pretax funds. Before 2015, the portion of a 401(k) already taxed often caused a portion of the pretax funds to be taxed in the year of a rollover.
Before 2015
Until 2015, both pretax and after-tax funds in a 401(k) were rolled over into new IRA accounts on a pro rata basis. There was no choice in allocating pretax funds to one new account and after-tax funds to another. The relative percentage of after-tax and pretax funds in the 401(k) remained the same when determining the tax status of the new IRAs.
If 10 percent of the 401(k) balance was after-tax, only 90 percent of the new IRA account remained pretax. Paying tax on the 10 percent was not a double tax. Instead, tax was essentially being paid early on 10 percent of the remaining IRA balance. The pretax balance in the new IRA was diminished by the taxed amount, lessening its long-term effectiveness.
2015
The IRS now allows a segregation of pretax and after-tax funds when you roll over a 401(k) to two or more IRAs. If you roll over the entire 401(k) balance, you can move all the pretax funds into a traditional IRA and all the after-tax funds into a Roth account. The advantage of the rule change is that you may have no income tax on the rollover.
If your employer's 401(k) plan allows it, there is now an added incentive to contribute after-tax dollars. Instead of simply deferring tax on account earnings, the after-tax amounts can be used to fund a Roth account. Once the funds are in a Roth account, distributions are typically tax-free, including accumulated earnings.
A partial rollover of a 401(k) is not as straightforward as a total rollover. If you roll over less than the entire balance of a 401(k), a portion of the rollover may be taxable. Contact a financial specialist for further information on planning a 401(k) rollover.
For more information, contact Krosnar & Griffith PC CPA or a similar firm.
Share31 August 2015
I still remember the day that my wife and I bought our first home. We were excited about filling the place with new furniture and looking for great area rugs. Unfortunately, before we knew it, we found ourselves deeply in debt. It was difficult to dig our way out, but over the course of the next several years, we were able to make things right. I want to teach other people how to manage finances so that they can avoid the turmoil that we went through. Financial planning might seem impossible, but with a little practice, I know it can become second-nature.