Here’s a detailed explanation of how you can benefit from the basis isolation rules that came out in September 2014.
The IRS has issued guidance on allocating basis when making a rollover from an employer plan. This page explains how you can benefit if you’ve made after-tax contributions to a retirement account where you work.
See also our separate article on the IRS release: Isolating Basis for a Roth Conversion
Suppose you’ve built your 401k account to $100,000. Most of that money is pre-tax: deductible contributions, employer match, and investment earnings. Along the way, though, you’ve also made $30,000 in non-deductible contributions. These after-tax dollars went into a traditional account, not a designated Roth account. Even though they’re in a traditional account they create basis, which means you don’t pay tax when you withdraw them.
Withdrawals are generally treated as a blend of pre-tax and after-tax dollars. At some companies, any withdrawal would be treated as coming from the overall $100,000 account. In this case, 70% of the withdrawal would be taxable, because your after-tax dollars made up only 30% of the account.
Fortunately, your company maintains a separate subaccount for after-tax contributions and the investment earnings they produce. (For an explanation of these subaccounts, see Basis Recovery from Employer Plans.) In your case, the subaccount has a value of $40,000, because the after-tax contributions have produced $10,000 of investment earnings. If you take a withdrawal from this subaccount, only 25% of the payout will be taxable because 75% of the the subaccount consists of after-tax dollars.
The new rules do not make it possible to withdraw the after-tax dollars while leaving the pre-tax dollars (the investment earnings) in the employer plan. If you withdraw $30,000 (the amount of your after-tax dollars), 25% of that withdrawal will be taxable, and 25% of your after-tax dollars will remain in the employer plan.
Getting to a better place
As long as the after-tax dollars remain in the employer plan, all the investment earnings they generate will be tax-deferred. That’s potentially better than having that money in a regular, taxable investment account where earnings are taxed each year, because tax-deferred compounding allows money to grow faster.
You could do even better, though, if these after-tax dollars were in a Roth account. Investment earnings in these accounts are not merely tax-deferred, but entirely tax-free if you leave them in the account long enough. Your goal is to move the after-tax dollars from the employer plan to a Roth account.
The simplest way to do this is a direct rollover of the $40,000 in the subaccount to a Roth IRA. That does the trick, but it requires you to pay tax on the $10,000 of investment earnings in the subaccount. Many people would prefer not to pay this tax, and some aren’t able to come up with the money.
Can you move the $30,000 in after-tax dollars to a Roth without paying tax on the $10,000 in pre-tax dollars? The answer is yes, but before the IRS changed the rules, methods for accomplishing this goal were awkward and, for some people, all but impossible. For example, you could have had the company pay the entire $40,000 in the subaccount directly to you. After you receive the money, you can roll $10,000 to a traditional IRA and the remaining $30,000 to a Roth IRA. The problem? Mandatory income tax withholding applies to the taxable portion of the distribution. To complete your rollover, you would have to come up with funds from another source to replace the dollars that were withheld. For some people this simply wasn’t feasible.
New rules make it easy
The September 2014 guidance from the IRS makes it easy to accomplish your goal. Instruct your employer to divide a single distribution from the subaccount into two simultaneous payments, with the $10,000 in pre-tax dollars going directly to a traditional IRA and the $30,000 in after-tax dollars going directly to a Roth IRA. Under the new rules, the IRS will respect this allocation of basis. Here are the consequences:
- No withholding. Your employer can make these transfers without withholding income tax from either part of the distribution.
- Tax-free rollover. The transfer to your traditional IRA is a tax-free rollover. Those dollars can continue to produce tax-deferred investment earnings, but they will be taxable when you withdraw them.
- Tax-free conversion. The transfer to your Roth IRA is a what we call a Roth conversion, but because it does not include any pre-tax dollars, it does not result in any taxable income. Investment earnings produced by these dollars will be tax-deferred and, if you leave them in the account long enough, they will be entirely tax-free.
In short, this is a cost-free transaction that has the potential to produce significant future tax savings. You’ll need to report the transaction on your tax return, but it won’t affect the amount of tax you pay.
Variations on a theme
The most common use of this rule will be a split rollover as described above. Here are some other ways the rules can be used:
- You’ve taken a job with a new employer. You can do a split rollover that sends the pre-tax dollars from the retirement account you had at your former employer to the new employer’s retirement plan and at the same time sends the after-tax dollars from the old employer’s plan to your Roth IRA.
- You want to withdraw some of your after-tax contributions without paying tax on any pre-tax dollars. You can tell the company to make a split payment with the pre-tax dollars going to your traditional IRA and the after-tax dollars going to you individually.
- You want to withdraw money from your Roth 401k account but you aren’t yet able to take a qualified distribution, in which the earnings would be tax-free. Unlike Roth IRAs, designated Roth accounts in employer plans have a rule that requires earnings to be distributed along with after-tax dollars. Using the new rules, though, you can reach this money without paying tax. Tell the company to split your payment so the earnings portion (the part that would be taxable) goes to your Roth IRA and the tax-free basis portion goes directly to you. The Roth-to-Roth transfer is a rollover, not a conversion, so it’s tax-free.