10% Penalty for Earnings on After-Tax 401(k) Contributions
If you take your after-tax contributions out of your 401(k) pre-59 1/2, is there a 10% penalty on the earnings from the after-tax money? I know that the earnings are taxed as ordinary income but I can’t find anything on the 10% penalty on that money.
Permalink Submitted by Alan Spross on Tue, 2008-05-20 00:27
1) If the separation from service at age 55 exception applies, there would be no penalty.
2) If not, then only pre 1987 after tax contributions can come out by themselves, tax and penalty free. The post 1986 after tax contributions can only come out pro rated with pre tax amounts. The penalty and taxes would apply only to the pre tax portion which automatically would include the earnings on the after tax contributions.
Note that pre 1987 after tax amounts can only be taken separately if the employer adequately separates and accounts for those amounts. Often, the balance will show on the periodic 401k statement.
Permalink Submitted by Jim Shope on Thu, 2008-05-29 17:35
Hi Alan,
I have read several of your posts relating to the after-tax portion of a 401k plan. Please explain what you mean when you say “pro-rated” in reference to after tax 401k contributions made post-1986.
I have a 401k that I am considering rolling over. The account is worth about $30,000 and the plan admin told me that about $2,000 of it is from after tax contributions.
I am not 59 1/2 (or near 59 1/2) and am considering taking the after tax contribution and putting it in a taxable account because I don’t want to deal with the record-keeping if I roll it over.
Will I incur a penalty on this $2,000 payout?
Thank you,
Jim
Permalink Submitted by Al Fry on Thu, 2008-05-29 20:12
Pro-rata means if you take out $2,000 in your example, only $133 would be after tax the rest pre-tax, and you would still have to file an 8606 for both the distribution and rollover. The record keeping is not that bad, the 8606 is one page and fairy simple.
Permalink Submitted by Alan Spross on Thu, 2008-05-29 20:48
Right. And there is no early withdrawal penalty or tax on whatever amount is allocated to after tax contributions.
What remains to be clarified is the new direct Roth conversion first available this year. In your case, IF you were allowed to transfer the 2,000 directly to a Roth IRA and the remainder to a traditional IRA, you would have two benefits:
1) You would get the 2,000 into a Roth while avoiding the pro rate rules of converting through a traditional IRA. It would be tax free.
2) You would have no basis in your traditional IRA, thereby avoiding the 8606 filing for many years into the future.
The distribution from the 401k would be total, but would be split into two different directions. The pro rate rules for plan distributions does not apply when your total balance is transferred, but if you transferred only half your balance, then only 1,000 of your after tax contributions would come out of the plan.
The problem is that the only guidance from the IRS on this so far is Notice 2008-30, and this particular issue is not clarified whatsoever by that Notice. In addition, a 401k plan does not have to offer more than one direct transfer recipient. You may wish to wait until the above is clarified.
Permalink Submitted by Jim Shope on Fri, 2008-05-30 18:57
Well, that certainly is crummy (the pro-rated thing – now that I understand it). The lady on the phone (from GE’s 401k) told me that I would not owe any tax, nor penalty on the distribution. She then asked me if I was ready to make the transfer. I told her I’d have to think about it, but what I really had to do was research it first to see if she knew what she was talking about.
So, you guys point out that she was wrong and now I don’t know what I should do. I will probably end up rolling the whole thing over and forget about the $2,000 that is pre-tax and just consider it after-tax. If I think about it at retirement when I start taking money out, then filing the 8606 may not turn out to be such a big deal, but $2,000 will be such a small amount of the account when I retire, it may not be worth it to deal with it.
…or I can wait and see what the news is about the Roth idea. That would be the ideal way to handle it – as long as it does not get counted as a contribution (I have already maxed out for 2008). Does the $100,000 income limit come into play with the new rules?
Thank you both for your excellent answers.
Jim
Permalink Submitted by Alan Spross on Sat, 2008-05-31 03:06
Yes, the 100,000 Roth conversion income limit applies to the usual conversions and to the new direct Roth conversion through the end of 2009. After that the conversion income limit is gone.