401(k) Distribution
❓ ❓
I have a client that was recently advised by another firm to initiate a transfer of 401(k) plan assets to an IRA. Unfortunately the client firm completed the paperwork incorrectly and did not consider the clients after-tax contributions. My understanding in speaking with the client is that the after-tax contributions have now been co-mingled with the pre-tax funds within the new IRA. It appears however that in reviewing the distribution summary that the pre-tax funds have been considered taxable also. The details follow:
Total Distribution Amount $115,277.49
Return of after-tax contributions $41,726
Total Taxable Amount $73,551.49
Ordinary Income Amount $73,551.49
Elgible for Rollover $115,277.49
IRA Rollover Amount $115,277.49
Two Questions. 1. Can anything be done to reverse this original transaction and move the after-tax portion to a taxable account and the pre-tax portion to an IRA? 2. Would it be advisable if the prior cannot be reversed to consider the conversion of the traditional IRA component to a Roth IRA and utilize a portion of the after tax funds to pay the tax?
Permalink Submitted by Alan Spross on Wed, 2008-07-09 16:17
1) No. Once the funds are in an IRA, the only way out is to distribute them using the basis percentage rules per Form 8606. Also, since the after tax amount was tranferred, an 8606 needs to be filed to report the added basis in client’s IRA accounts The distribution breakdown you posted properly reflects a total transfer of the 401k plan and the tax reporting status.
2) The conversion decision cannot be properly made without a thorough analysis including the tax cost and estimated marginal tax rate in retirement. However, you are correct that the % of basis the IRA now holds makes conversion more attractive than otherwise because the current tax cost is much less per dollar converted. Client should be able to pay the taxes from funds other than those included in the conversion. The 100,000 MAGI limit applies to conversions until 2010, although the converted amount does not count toward the 100,000.
Permalink Submitted by Jeffrey Bartleson on Wed, 2008-07-09 16:38
❗ ❗ ❗ ❓ ❓ ❓
Alan,
Thanks for your response. I’ve just reviewed the past 10 pages of posts and noticed your responses quite frequently, you seem quite knowledgeable.
My understanding of your response is that by filing form 8606 the client can report the higher basis on the after-tax amount and avoid paying a higher amount of tax upon distribution if the after tax amount was considered pre-tax without the increase in basis. However the client will still end up paying income taxes on these funds again upon distribution at their effective Federal rate and that this is unavoidable, correct?
My interpretation of the distribution summary indicates that the pre-tax amount of $73,551.49 is also considered taxable and the client will have to add that amount to their oridinary income for the current year and will then be taxed on the total combined amount for the current tax year. Is this correct also? And if so, doesn’t this imply that the pre-tax amount was never transfered correctly to a TIRA either? If this is the case the client should at the very least be able to take advantage of the 60-day window to move the pre-tax portion back to a TIRA, correct?
Thanks for your assistance.
Permalink Submitted by Alan Spross on Wed, 2008-07-09 17:04
No, there is no current tax at all here because the entire plan was rolled over to an IRA. It wll be reported on Form 1040 as a rollover on line 16 and then the 8606 is added to show the $41,726 added basis to the IRA. This prevents any double taxation when funds are distributed from the IRA or converted to a Roth IRA.
If the client wanted the after tax portion to be distributed to him rather than transferred to an IRA, then he should determine who is responsible for the error in the transfer paperwork. If the other firm is fully responsible for the error, the client may have recourse against them. While there is no double taxation on the after tax amount itself, in order to withdraw the funds from the IRA, he will have to withdraw some taxable amounts also under the pro rate rules.
Example: Say he already has an IRA of around 85,000 and with the transfer his total balance is now 200,000. 41,726 is his after tax basis that will go on his 8606, so his total balance is 20.86% after tax. In order to withdraw the 41,726 from the IRA, only 20.86% will be tax free and he would owe income tax on about 33,000 of the distribution.
There is only one way to reverse the tax effect on the transfer, and it is very much a long shot. If he is working and his current company will accept an incoming rollover from his IRA, he could roll the pre tax amount into the employer plan. The plan CANNOT take after tax amounts. That would leave him with an IRA of 41,726 and he could withdraw it tax and penalty free. The problem is that very few employer plans will accept an IRA containing after tax contributions because they are afraid they will end up with some of those contributions, and that could disqualify the plan. It may be worth checking out however.
Again, note that there is no current tax on the rollover itself, and the 41,726 that was taxed once already, will NOT be taxed again. The problem is that in order to get the 41,726 out of the IRA, pro rated amounts of the pre tax funds will also have to be taken and will be taxed. This pro rating goes on forever as long as he has a traditional IRA, even after RMDs start at age 70.5.