Basis Recovery from Employer Plans

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.

401k basis recovery
401k basis recovery

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

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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

Prior to September 2014, the availability of separate subaccounts was important in minimizing the tax impact of a withdrawal that includes pre-tax and after-tax dollars. The practical importance of these rules is much smaller now that we have an easy way to separate the pre-tax dollars from the after-tax dollars. See links below to pages discussing basis isolation.

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