Tax consequences for commingled money rolled over from 401k to Traditional IRA to Roth IRA

Question

A 401k account with pre-tax and post-tax funds at Institution A is rolled over as one lump sum into a new Traditional IRA at Institution B. The funds are commingled at this point. The funds will next be rolled over into a new Roth IRA at Institution B, which was the original intent. Institution A has an amount breakdown of how much is pre-taxed and post-taxed.

• Once the funds are rolled over into the Roth IRA, is there a way to inform the IRS that a potion is already post-taxed money? I do not want to be double taxed on the post-taxed money.

• I understand I will have to pay income taxes on the pre-taxed funds, but are there other tax consequences for handling the funds in this manner?

Answer 1

There are several things to remember and keep in mind:

1. Pre-tax contributions and Roth contributions cannot be commingled. It may be that your contributions were "post-tax" yet not designated as Roth, or it might be that your plan administrator made a horrible mistake. If its the former - lets go to the next bullet, otherwise start calling your plan administrator and have it fixed - roll over the Roth part to Roth IRA, and non-Roth part to the Traditional.

2. Assuming the whole amount is non-Roth - the "post-tax" portion was not deducted from taxes, and thus is basis to your balance. I.e.: If you contributed 1K post tax, 1K pre-tax, and you have 8K gain (on everything), your total is 10K, and your basis is 1K. This is important to remember for IRA Roth conversion.

3. Roth conversion: you pay taxes on all the non-taxed (above basis) amounts per your ordinary income rates. It is added, in essence, to your salary. What does it mean "above basis"? Remember the example from the previous bullet - total 10K that include all contributions and gains, and 1K basis (the amount you contributed post-tax). You pay tax on the 9K (10K total - 1K basis). So rolling over your whole balance and converting it to Roth may be quite a tax hit.

4. Be careful of too many roll-overs - you cannot rollover more than once a year. Generally, "rolling over" from a traditional to Roth IRA is considered a "conversion", not roll-over, but check with the IRA custodian how they're going to report this. If the IRA A and IRA B are not at the same custodian, it will probably be reported as another - second - roll over. So be careful here.

Here we see the difference between "post-tax" contribution and "Roth" contribution. While seemingly they're the same, the big difference is the treatment of gains. For the "regular but post-tax", gains are considered as if it was a "regular" contribution, and are taxed on Roth conversion. For Roth contributions - the gains are considered Roth as well.

So if you want to do "post-tax" contributions - always do Roth, otherwise you're kindof missing the point....