Taxable vs. Non-Taxable 401k Distribution | Ed Slott and Company, LLC

Taxable vs. Non-Taxable 401k Distribution

Taxpayer retires and decides to rollover entire balance of 401K to an IRA. Total accumulation is $500,000. $50,000 represents employee after-tax contributions. The balance is employer contributions and accumulated earnings. The 401K trustee issues two checks. One check for $50,000 an amount exactly equal to employee after-tax contributions and mailed to employee. The other check is a direct rollover to IRA for $450,000. Question: Is the entire $50,000 considered a non-txable distribution, or must it be allocated between taxable and non-taxable portions (10% non-taxable and 90% taxable) as is required for a traditional IRA distribution given total IRA account is made up of both deductible and non-deductible contributions of the years.

This two part transaction has always been segmented with the pre tax amount going to the TIRA and all the basis paid to the employee. However, with the advent of direct conversions to a Roth IRA in 2008, the IRS has created massive confusion that includes possible pro rating of both the TIRA rollover and the second check paid to the taxpayer. Following is copied from IRS Notice 2009-68 with respect to after tax amounts: >>>>>>>>>>>>>>>>. If your payment includes after-tax contributions After-tax contributions included in a payment are not taxed. If a payment is only part of your benefit, an allocable portion of your after-tax contributions is generally included in the payment. If you have pre-1987 after-tax contributions maintained in a separate account, a special rule may apply to determine whether the after-tax contributions are included in a payment. You may roll over to an IRA a payment that includes after-tax contributions through either a direct rollover or a 60-day rollover. You must keep track of the aggregate amount of the after-tax contributions in all of your IRAs (in order to determine your taxable income for later payments from the IRAs). If you do a direct rollover of only a portion of the amount paid from the Plan and a portion is paid to you, each of the payments will include an allocable portion of the after-tax contributions. If you do a 60- day rollover to an IRA of only a portion of the payment made to you, the after-tax contributions are treated as rolled over last. For example, assume you are receiving a complete distribution of your benefit which totals $12,000, of which $2,000 is after-tax contributions. In this case, if you roll over $10,000 to an IRA in a 60-day rollover, no amount is taxable because the $2,000 amount not rolled over is treated as being aftertax contributions. >>>>>>>>>>>>>>>>> Since this Notice, major employee benefit administrators have appealed to the IRS to clarify this issue, but mostly with respect to isolating basis for Roth conversion purposes. Overlooked in this process has been the more traditional practice of simply paying the after tax amount to the taxpayer, who does NOT desire to roll it over. Prior to 2002, the after tax contributions could NOT be rolled over, but since that time the IRS has never questioned the isolation of pre tax and after tax amounts. But this Notice appears to require pro rating, although the 1099R instructions for the plan administrators have not been changed. As it stands now, the taxpayer will still get a separate 1099R for the after tax amount showing no taxable amount in Box 2a. Until the IRS changes the 1099R instructions, it appears that taxpayers will still be able to treat these distributions as they have all along.

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