By Echo Huang, CPA, CFP®, CFA
Last month, one of my new clients and I called the administrator of her old 401(k) plan to rollover the balance to her IRA account at TD Ameritrade. To her surprise, she had $36,000 in after-tax contributions (not the same as a Roth) with earnings of $70,000 from the after-tax contributions she made many years ago in addition to $700,000 pre-tax contributions and earnings. She was able to request two checks - one for the $36,000 to a new Roth IRA account (a Roth conversion that is tax-free because there is no taxation on otherwise after-tax funds!) and one for the $770,000 to a traditional IRA account (which does not incur an income tax assessment by virtue of being a rollover). The end result – now she has $770,000 of all pre-tax funds in an IRA, $36,000 in a Roth IRA, and her tax cost this year is zero!
One great benefit is that the balance in her Roth IRA account will now grow tax free! It was a pleasant surprise for both her and for me, but I thought to myself “If she had rolled-over the $36,000 to her Roth IRA earlier in 2014 or 2015, the earnings from this after-tax contribution in the past two to three years (i.e. $7,000) would have been tax-free instead of being in an IRA that will be taxable upon distribution.” And this made me want to tell you, that if you have made any after-tax contributions to your 401(k) from before the Roth 401(k) became available, you should consider reviewing the plan provisions on in-service withdrawals if you still work for this company. If you have already left or retired from this company, it’s still easy, you can do what my client did. But leaving an after-tax balance in the plan does not help you grow tax-free because the earnings from the after-tax contributions are taxable if you take distributions from the plan to spend in the future.