Tax 401(k) Questions
Investors often get confused with the many differences in IRAs and 401(k)s, particularly surrounding how they are treated regarding tax implications. In the most basic terms, IRAs and 401(k)s are all vehicles used to help you save for retirement, they just differ in the time in which you are taxed and if your employer offers the plan or not.
Differences Between a Traditional IRA, Roth IRA, and a 401(k)
A 401(k) plan is offered through your employer, while an IRA (either a Roth or traditional) may be obtained outside of your employer. With a traditional IRA or a 401(k), you pay taxes at the time of withdrawal (during retirement most likely) and the money that you’re putting into the investment is put in pre-tax, so it is lowering your taxable income. With a Roth IRA, you’re putting the money into the investment post-tax, after you’ve already paid tax on it, so you aren’t charged a tax later when you withdraw that money from your Roth.
What’s a pre-tax contribution?
It’s called a pre-tax contribution when you elect to contribute to a retirement account such as a 401(k) from your salary prior to taxes being taken out of that money. You haven’t paid tax on those dollars, and this contribution is tax-advantaged as it lowers your taxable income. When you eventually withdraw the money from the investment, you will then be taxed on the amount you take out.
What’s a post-tax contribution?
When you contribute to an investment account with money that has already been taxed, such as adding to a Roth IRA after you’ve been paid, this is a post-tax contribution. Since you’ve already paid tax on this money, you aren’t assessed tax when you later withdraw these funds. Roth IRA withdrawals do need to be qualified withdrawals, and the IRS indicates what constitutes a qualified withdrawal.
Converting After Tax 401(k) Money to a Roth IRA
If you’re in a situation where you have contributions in a 401(k) that are post-tax contributions, you may be able to roll those contribution amounts to a Roth IRA without paying taxes if you adhere to your plan’s terms and conditions per the IRS. When rolling post-tax contributions from a 401(k) to a Roth IRA, you want to avoid creating any taxable income, especially if you’ve already paid tax on those contributions previously.
In this situation, as with many financial situations that have potential tax implications, it’s best to consult with both a financial advisor and a tax planner to ensure that you’re making the right move for both your finances and your tax strategy. You’ll also need to abide by the rules of your retirement plan as set forth by the plan and your employer.
You may be able to roll your balance from your workplace 401(k) and put the pre-tax contributions into a traditional IRA while directing any post-tax contributions into a Roth IRA. This option is the most straightforward and tax-savvy if your plan allows for it. The IRS allows for you to take partial withdrawals, so you can take bits and pieces from your 401(k) and direct them into different places, however, it is ultimately up to your retirement plan administrator if they will allow partial distributions in this manner.
If you’re only rolling over part of your 401(k), you’d want to roll over the after-tax balance which would include any post-tax contributions, and place these into a Roth IRA. This scenario gets a little trickier though, as the IRS has ordering rules with retirement accounts, that require that when you roll over a partial amount of after-tax contributions you must bring overall taxable amounts of your plan.
Make a Plan
Before you embark on converting any post-tax 401(k) dollars to a Roth IRA, it’s a good idea to speak with both a financial advisor who understands your financial situation and goals and a tax expert that can help you navigate the intricacies of IRA rollovers. At Diversified Tax, we offer integrated financial planning and tax advisement, so that your planner and professional work in tandem for your benefit.
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