tax treatment of gains on after tax contributions to 401k - | Ed Slott and Company, LLC

tax treatment of gains on after tax contributions to 401k -

Is there a tax penalty on gains on after-tax (non-Roth) contributions withdrawn when plan is rolled over to an IRA. Situation: client has a pre-tax, roth, and small after-tax account in 401k. moving to a new employer. pre-tax maps to IRA. roth maps to roth. pre-tax maps to? Can we roll to his individual account? does he pay penalties on tax-deferred gains?

The gains on after tax contributions are treated just like pre tax contributions or company match contributions. Typically, they would be be rolled to an IRA tax and penalty free along with other pre tax amounts. It is the after tax contribution amount itself that is subject to debate if a Roth conversion is desired for those funds. The debate is how to isolate the after tax basis from pre tax amounts so that they each go to different IRA types. But your question appears to address just the gains on the after tax portion that occurred in the pre tax (non Roth) account. The transfer papers supplied by the plan should clarify the options that can be elected for each category of funds in the plan.

The way I read the regs and professional analysis, including Ed's, there is no clear-cut way to roll the after-tax amounts to an individual Roth IRA without involving pre-tax amounts - i.e. pro-rata conversion. And the pro-rata process would give us no value due to the low % this portion represents of his total account value. To to clarify your answer, if we were to roll the after-tax amounts into a brokerage account (defacto distribution?) then the gains represented in the total amount would be income taxed and penalized 10% because of his age?

No. If the after tax amount was transferred to a taxable brokerage account, there would be NO tax or penalty on these amounts. But the gains on those after tax contributions would not be part of this amount. The gains would be peeled off and added to the other pre tax dollars sent to a TIRA in a direct rollover. A separate 1099R would be issued for the pre tax rollover (coded G). The 1099R for the after tax amount would show nothing in box 2a as taxable. And if there is no taxable amount, there is nothing to penalize. Now, if you wanted the after tax contributions to be included in the direct IRA rollover, you would be adding basis to your TIRA. IRS instructions indicate that a Form 8606 should be filed to report the added basis in your IRA NOT in the year of the rollover, but in the first year after that in which a distribution was taken. The result would be that a pro rate portion of the IRA distribution or conversion would be tax free. The hassles begin when the employee wants the after tax amount sent in total to a Roth IRA. But there IS a way to accomplish that without the risk of the IRS inflicting pro rate rules on the plan distributions. The work around involves doing an indirect distribution (distribute to yourself) and then YOU roll the pre tax amount to a TIRA first and the after tax amount to a Roth IRA second. The kicker is that you must be able to replace the mandatory 20% withholding on the pre tax amount to complete the rollovers. You would get that money back when you file your taxes in the spring.
 

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