Rolling over a 401(k) to an IRA at retirement is a common strategy that people will use to continue investing their retirement savings. An important piece to consider is how your contributions have been classified over the course of your time working.
There are 4 ways contributions are typically made to a 401(k).
- Pre-Tax Contributions: The standard wage deferral option that is taxed upon distribution
- Employer Contributions: Typically pre-tax just like the above
- After-tax (non-Roth) contributions: Contributions are made after tax, while earnings are considered pre-tax
- Roth Contributions: Contributions are after-tax and earnings are tax-free.
The main thing to consider is that when you have after-tax (non-Roth) contributions in your 401(k) the earnings associated need to be separated when you go to rollover your account to an IRA. These earnings and any other pre-tax contributions must be rolled into a traditional IRA. Only the contributions made after-tax can be rolled into a Roth IRA. For actual Roth contributions, the earnings can also be rolled into a Roth IRA.
It is important that this is all pieced out before you begin any rollovers. If you try to rollover everything to a traditional IRA first and then move the after-tax portions to a Roth, you will run into the pro-rata rule that will cause tax complications. This will prevent you from rolling over only the after-tax balance in the IRA.
For example, let’s assume you have a retirement plan with $100,000.
- $90,000 is pre-tax
- $10,000 is after-tax
If this is coordinated prior to any rollover, all $10,000 of the after-tax portion can be moved into a Roth IRA.
The other scenario is if the $100,000 is rolled into a traditional IRA first. You cannot just rollover the $10,000 after-tax portion at this point. When you convert from a traditional IRA to a Roth IRA, you must convert in accordance to the percentage of pre-tax and after-tax money that is in the IRA. In this case, when you go to rollover $10,000, only $1,000 will be after-tax while the remaining $9,000 will be taxable. This entire situation is more complicated for tracking purposes to know which portion of the IRA is pre-tax or after-tax. This is why it is recommended to split your funds into the proper IRAs directly from your retirement plan.