By Jonnelle Marte
Question: My existing 401(k) balance consists of both before and after-tax contributions and related returns on investment. Can I rollover/direct transfer the after-tax portion into a Roth IRA in such a way that will not result in any tax liability as those contributions were already taxed? I’m worried that if I leave the after-tax money in my 401(k), then any future earnings on those funds will be taxable when withdrawn during retirement.
Answer: Unfortunately, you can’t move just the after tax dollars into a Roth IRA without incurring a tax bill. But the good news is that you would not be taxed twice on the contributions made with after tax dollars. Contributions made with after tax dollars are not taxed when you take a distribution from your retirement account, according to the Internal Revenue Service. You can rollover the whole account into a traditional IRA, but the portion of your savings made with after-tax dollars should remain tax free when you take distributions. To pull the non-taxable savings from your IRA in a distribution, you need to file Form 8606 in order to calculate how much of your distribution is nontaxable. You will still owe income taxes on contributions made with pre-tax dollars as well as earnings or returns from both.
But if you want to move only part of your retirement savings into a Roth IRA, a percentage of that amount will be taxed. The tax bill on a partial conversion would depend on how much of your savings are currently taxable. Say you have $100,000 in your 401(k) and $90,000 came from pre-tax dollars. Under this scenario, 90% of any amount that you convert into a Roth IRA would be taxed, and 10% would be untaxed, says Ed Slott, IRA expert and founder of IRAhelp.com. You might be better off converting the full amount now, while the lower Bush-era tax rates are still in effect, and pay income taxes on the portion of your savings made with pre-tax dollars, he says.
For future 401(k) contributions, keep in mind that there may better places for your after-tax dollars. If you qualify for a Roth IRA, they can grow tax free and you won’t have to pay taxes on eligible distributions taken in retirement. Also, depending on the kinds of investments you hold, you might be better off in a brokerage account, where your investment gains and/or dividends may be taxed at the currently lower capital gains tax rate.
Correction: In a previous version of this story, we incorrectly stated that you can’t move after-tax dollars into an Roth IRA; Savers can, but will have to pay the tax on a percentage of the amount converted.