Tax treatment of earnings when making a in-service rollover from After-Tax 401k to Roth IRA

Question

My employer offers three categories under 401k:

• Traditional
• Roth
• After-Tax

The Traditional and Roth are well-known and like the Traditional and Roth IRA. The sum of contributions to these are capped at around $19k annually by IRS. The After-Tax category can be used in order to make contributions in excess of $19k but the money going into it is taxed as well as earnings on it at time of withdrawal. Because of that people rollover the After-Tax money into a Roth IRA which is allowed and the background behind the so called mega backdoor Roth conversion.

My question is say I contributed $10k to after-tax and when I wanted to do the rollover the account has $11k in it. Thus it earned $1k. My company does not allow me to rollover just the original amount. I have to rollover entire amount. How much taxes will I be paying on the $1k earnings? Will it get taxed like ordinary income or is there any early withdrawal penalty I will have to pay (how much?) even though I am rolling over entire amount to Roth IRA?

Answer 1

The $1k earnings will be taxed like regular income, so whatever your marginal federal rate is, and don't forget state income taxes. There is no early withdrawal penalty; there never is on rollovers or conversions between tax-advantaged accounts.

Note that sometimes, plans will allow you to separately rollover the after-tax earnings back into your traditional 401(k) or a traditional IRA, while the contributions go into a Roth account. In that case they would not be taxed at time of the rollover, but instead when they are eventually withdrawn.

Answer 2

I want to mention that there is a way that you can just move the after-tax contribution amount into Roth IRA, and not have to pay any taxes. Although it is true that the pro-rata rule applies, and you therefore cannot distribute all the after-tax amounts without also distributing the pre-tax amounts from that account (and earnings in Traditional 401(k) are pre-tax), according this IRS page and Notice 2014-54, you can split the distribution such that after-tax amounts are rolled over into Roth IRA, and pre-tax amounts are rolled over into Traditional IRA.

You would not be taxed at the time of these rollovers, and it would accomplish essentially the same as rolling over just the $10k after-tax contribution to Roth IRA, except that the earnings are now in Traditional IRA instead of Traditional 401(k). (Depending on your 401(k) plan, you may be able to subsequently rollover those pre-tax funds from Traditional IRA back into Traditional 401(k).)

(By the way, as Notice 2014-54 pointed out, even before the notice, it was still possible to split the after-tax and pre-tax funds -- you could take the whole amount as a cash distribution, deposit the pre-tax amount in Traditional IRA as a rollover first, and then later deposit the after-tax amount in Roth IRA as a rollover. Existing rules already provided that a partial rollover from 401(k) to IRA would first come from the pre-tax part.)