Qualified Plan with Basis
I am working with someone who has told me that they have after tax monies inside their 401(k). He is 56 and is likely to retire within the next 12 months. I understand that he can use the age 55 exception within section 72 to avoid withdrawal penalties, but what are other options on withdrawals?
Assuming he leaves the money in his employer’s plan can he specify from which pool he is making a withdrawal? withdraw all of his basis tax free? or Is everything pro rata or LIFO/FIFO?
Additionally, if he does not need to use the monies for income can he move the cost basis out without tax into a taxable account? Then roll all pre-tax conributions and growth into an IRA?
Any guidance is appreciated.
Thanks,
Jim
Permalink Submitted by Alan Spross on Thu, 2007-10-25 21:06
Jim,
The first thing to do is assess any NUA potential in the plan prior to doing any distributions. To utilize NUA, a qualifed lump sum distribution must be done following separation, or he could wait until age 59.5, which is another triggering event.
The age 55 exception does apply, but for this option to mean much, the plan must also offer periodic or other adjustable distributions through age 59.5. Taking a large lump sum without penalty would not help if higher marginal rates more than offset the penalty relief.
If the plan separately accounts for any pre 1987 after tax contributions, those can be distributed separately prior to other distributions. Other after tax amounts must be distributed pro rata with pre tax amounts. The after tax contributions can be used in conjunction with NUA, with the after tax amount reducing the taxable cost basis of the NUA shares, but not the NUA cost basis.
For non NUA after tax amounts, he has the choice to take a tax free distribution or to roll over the after tax amount to an IRA and file Form 8606 to report the added basis in his IRA.
As if the above were not enough, yet another planning opportunity arrives in 2008, when direct Roth conversions from the 401k can be made if his modified AGI does not exceed 100,000. While the official Regs have not been released, there is a good chance that the after tax amount could be converted tax free to the Roth IRA, and the pre tax amount transferred to a TIRA. This type of conversion avoids the use of 8606 to determine the taxable amount of a traditional conversion based on all TIRA values.
The above options present a variety of ways to avoid setting up a 72t (SEPP ) plan for the 5 years following his separation. Since he will only have a couple years prior to 59.5, he ought to be able to avoid a SEPP using a combination of the other tax saving strategies. It will be a challenge to come up with the best strategy considering all the variables in play here.