How To Handle That Pesky After Tax 401(k) Money
You’ve done a great job investing in your 401(k) at your job. Then you decide to leave that job to a better paying one. So, you decide that you want to rollover your 401(k) to an IRA. Here’s an overview of how to do this rollover correctly. By doing this, this opens up your 401(k) to all the great investment options offered in a typical brokerage account. Great, you go to your plan administrator to fill out the paperwork and they tell you that you have after tax money in your 401(k) which can’t go over to the IRA. After tax money?!? Aren’t 401(k)s always pre-tax money?
How This Can Happen
401(k) accounts are not prevented from containing after tax money, they are designed to handle it. The money you contribute still grows tax deferred, it’s just that it exists in a different ‘pot’ than the other money. After tax money can find its way into your account if the contribution limits from your employer are higher than the tax deductible contribution limits set by the government. The typical plan will allow you to set a “percentage” of your income that you want to contribute. These are fairly flexible, you can, for example, contribute a higher percentage early in the year and change it at any point to a lower percentage during the year.
If the the total contribution percentage results in more money than is currently deductible, the extra money is added after you pay taxes on it. Here are the limits for 2011 and 2012.
If you earn $150,000/year and contribute a percentage of 15%, your total contribution to the plan will be $22,500. Of this amount, $6,000 is over the 2011 limit of $16,500. This $6,000 will go into the plan as after tax money.
Every plan is different, but all the money you put in plus what your employer puts in combined is limited by that bigger number above, which for 2011 is $49,000.
401(k) Rollover Options For After-Tax Money
There are a couple of different options for this money when you decide to rollover the 401(k).
- Ask for a check – The plan simply issues you a check for the money to do with as you wish. There isn’t any additional consequences.
- Move to a brokerage account – Ask your broker to setup an additional taxable brokerage account to take the cash (if you don’t already have one). This separate account will be added to your taxable investment portfolio.
- (Advanced) Rollover to a non-deductible IRA. This option will enable the money to continue to grow tax deferred.
In most cases, the amount of money in this pot will be small, so typically option 1) or 2) is preferable. For my own situation, I generally try to keep within the ‘deductible’ limits, so over the years I’ve accumulated just a few hundred dollars of after-tax money.
A Word About Excess Contributions
In the example above, you worked for one employer who correctly handled the extra contributions. Another situation you should be aware of is when your earnings span multiple employers. This can create a situation called ‘excess’ contribution which could cause you some headaches. Here’s how it might happen:
Employer #1 (150K salary):
2011: Jan-Jun, contribute 15% ->> 11,250
Employer #2 (150K salary):
2011: Jul-Dec, contribute 15% ->> 11,250
Employer #2 doesn’t know anything about Employer #1 so they don’t limit your pre-tax contributions. Across both employers you contributed $6,000 over the limit of $16,500. It’s up to you to either limit your contribution level to prevent this or be sure to ask your administrator to refund the difference after the plan year completes.