Contributing to a 401(k) is simple, right? Not in this instance.
Scott: And we're going to talk with Kevin. Kevin, welcome to Hanson McClain.
Kevin: Hi, guys. How are you doing? Thanks for taking my call.
Scott: Thanks for calling, Kevin.
Kevin: Yeah, my call is about converting a 401(k) balance to a Roth IRA. I picked up somewhere that I had a particularly attractive chunk to do that with. It's an amount in the mid-five figures that represents after-tax contributions. Our plan is funny. They only let you designate your contributions in even percentages. So in order to hit the max, I always overshoot by a bit every year. And I've been doing this overshooting for over 20 years. I'm currently in that phase now. I kind of forget about it. And then my checks in December come up short. But in any event, I have this amount. And I'm wondering...I assume if you could...
Scott: So you have some contributions that have been in an after-tax format, is that correct?
Scott: And not all 401(k)s ... for the rest of the listeners, not all 401(k) plans allow this. But some, and typically, it's probably a large employer, and it's probably an older plan, been around a long time, I guess.
Kevin: Yeah, yeah, well, yeah, it has been around a long time. It's also annoying. It does not automatically default into the over 50 bucket. But you have to jump through a bunch of hoops to, you know, direct your contributions there. So I just kind of let it go.
Pat: So how much do you have in after-tax contributions in this plan?
Kevin: In after? Well, as I said, it's a little over 50k.
Scott: Now, is that the balance of your after-tax contributions?
Pat: Or the contributions?
Kevin: That is the market value of the over all these years that's being tracked separately, you know, the after-tax contributions. So this is the current balance which would represent the amount of those contributions plus whatever growth there's been.
Scott: “Growth there has been,” that's the key term here.
Pat: How old are you, Kevin?
Pat: Okay. And what’s your question for us?
Kevin: The question is...somebody told me that that was a particularly attractive balance to roll into a Roth.
Kevin: Well, what I really want to do is confirm if my understanding is right and that, I guess, it’s particularly attractive, because the tax you would pay is not on the entire $52,000. It's on the growth portion as opposed to the basis, if you want to call it that, the contribution amount.
Pat: Well, you don't have to pay any taxes at all to roll this over into a Roth.
Scott: Of the contributions.
Pat: Of the contributions.
Scott: You're correct here. So what you've got going on is this. Let's say that the after-tax balance is $50,000. Then for the rest of the listeners, if you look on your statements, if you have any, you'll know it's there, because it will state "After Tax." But let's assume your contributions are $20,000. So you had $20,000 you've already been taxed on. The $30,000 in growth, you've yet to be taxed on.
Now, right now, in the 401(k), let's assume that you never contributed another dime again. And let's just assume that the 401(k) just sits there. And now, 10 years down the road, that $50,000 balance, let's assume that's now $100,000, right? So we've just had an additional $50,000 of growth. Because it grew in the 401(k), that additional $50,000 of growth is all going to be taxable to you.
Pat: And in a Roth, it would not be taxable to you.
Scott: So in a perfect world, if we could take that $20,000 contribution and stick that into a Roth IRA and then allow the growth to occur there, whatever growth occurs will be tax-free.
Pat: So remember, the difference is you only want to roll over the contribution amount to the Roth so that you have no tax implications on whatsoever.
Scott: So what's unique about these dollars, it allows you the ability to transfer into a Roth without any tax consequences whatsoever. You can essentially take a balance that you would have the earnings taxed and move it to a balance where the earnings will be tax-free. Here's the problem you've got.
Pat: Here is the rub.
You still are employed by that company, correct?
Pat: And they may not allow you to do what's called an in-service rollover. Have you checked on that?
Kevin: No, but that was a question I was going to ask you guys, not whether it was permitted, but whether many plans might not permit it, which I expect might be the case. I would have to find out.
Pat: Are you comfortable telling us the name of the company? Your employer?
Kevin: I'll tell you the name of the plan administrator, it's Schwab.
Scott: Yeah, that's irrelevant, every company's different. So check with your employer to see if they allow for an in-service withdrawal. If that's the case, you can transfer some portion of this.
Pat: Now, here comes the rub, the second rub, right?
Scott: We just answered your question, theoretically, yes?
Pat: Yes, it's allowed by law. But here, you've got two things that you need to worry about. One is do they allow in-service rollovers? Okay, let's come back and if they say no, then forget the conversation.
Scott: And then you have to wait till you're 59½ .
Pat: And you're going to wait until you're 59½ .
Scott: But you do it at 59½ .
Pat: But let's say they say, "Yes, we do allow for an in-service rollover," then you have to go back to the plan administrator and say, "How much money do I need to roll over to capture all $20,000 of that contribution?" And it may be half of the plan or a quarter of the plan.
Scott: Or all of the plan.
Pat: Or all of the plan.
Scott: Which they may not allow.
Pat: Which they probably don't allow.