Basis Recovery from Employer Plans
By Kaye A. Thomas
Current as of March 24, 2013
A withdrawal of after-tax contributions from an employer plan will normally be proportional to investment earnings produced by those contributions but not to other amounts in the retirement account.
Subject to various limitations, 401k plans and other retirement plans maintained by employers can offer the opportunity to make nondeductible contributions instead of, or in addition to, deductible contributions. These work somewhat like nondeductible IRA contributions: they permit tax-deferred buildup of investment earnings, and they create basis in the account so that the portion of your subsequent withdrawals representing these after-tax dollars will not be taxed again. The rules for recovering basis from employer plans are not the same as for IRAs, however. There is no requirement to aggregate accounts in different employer plans. Furthermore, basis is not necessarily recovered in proportion to the overall account.
Contributions made before 1987
Prior to the Tax Reform Act of 1986, individuals who made after-tax contributions to employer plans could generally withdraw those contributions without taking any taxable dollars from the plan. This generous rule was retained for contributions made before 1987, provided that the plan permitted in-service distributions as of May 5, 1986.
Contributions made after 1986
After-tax contributions to employer plans made after 1986 are recovered pro rata with taxable amounts. However, they are not necessarily prorated against all taxable amounts in the account. These after-tax contributions, together with their earnings, can be maintained as a separate subaccount. Investment earnings have to be allocated to this subaccount according to IRS rules, but it remains separate from other portions of your overall retirement account, including your pre-tax contributions, employer matching dollars, and investment earnings on these amounts. When accounts are maintained in this manner, a withdrawal from this subaccount will be prorated between your after-tax contributions and the investment earnings they have generated, but not other amounts.
Example: Your 401k account has a value of $100,000. Of this amount, $15,000 is from after-tax contributions and $5,000 is from earnings on those contributions. The remaining $80,000 is from pre-tax contributions, employer matching dollars, and earnings on those amounts. If the plan has maintained your after-tax contributions in a separate subaccount and you’re able to withdraw from this subaccount, 75% of that withdrawal will be tax-free, even though basis represents only 15% of your overall account value of $100,000.
Designating the separate subaccount
How do we determine whether money is coming from this separate subaccount? That depends on how your employer set up the plan. It’s permissible to let the account owner choose whether a particular distribution comes from this subaccount. Some plans take a simpler approach, though, specifying that money will automatically come first from any pre-1987 after-tax contributions, then from the subaccount maintained for post-1986 after-tax contributions and investment earnings generated by these contributions, and finally from other amounts.
Availability of separate subaccount treatment
Employers are permitted but not required to make this separate subaccount treatment available. When these rules were first created, in 1986, some employers may not have had systems in place to maintain these subaccounts. Recordkeeping systems now in use should handle this feature easily. Some employers (and some tax professionals) may not realize that separate subaccount treatment is permitted, or may mistakenly believe it is available only for in-service distributions. For the benefit of those employers and tax professionals we have a separate page explaining the legal basis for separate subaccount treatment.
What this means
These rules generally mean good news for Roth conversions.
- If you made after-tax contributions before 1987, it’s likely that you can do a tax-free Roth conversion of that portion of your account.
- If you made after-tax contributions after 1986 and the plan maintained separate subaccounts for these dollars, any withdrawal from this subaccount will be proportional between these contributions and the investment earnings they produced. If earnings represent a small fraction of this subaccount, a Roth conversion of the amount in this subaccount is likely to be highly advantageous.
The tax cost of conversion will be higher if earnings represent a large fraction of the subaccount, or if the plan did not maintain subaccounts so that your withdrawal will be proportional to the entire account. A Roth conversion may still be advantageous — after all, these conversions can make sense even when they are 100% taxable. If the tax cost seems too high, however, you may wish to consider whether you can isolate your after-tax dollars from the rest of your account for a tax-free conversion.
- Isolating Basis for a Roth Conversion
- Isolating IRA Basis
- Basis Recovery from Employer Plans
- Separate Subaccount Treatment
- Simple Payout
- Using an IRA to Isolate 401k Basis
- Split Rollover Methods