Keeping Your Roth 401(k) Balance Separate During an IRA Rollover

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I recently received the following reader question:

For years, I have contributed to the pre-tax side of my 401(k). I would like to switch to post-tax Roth deferrals now, but I am worried. What would happen if I tried to rollover my 401(k) to an IRA? Would it convert my pre-tax portion? Would I lose my Roth?

Having a 401(k) plan with both pre- and post-tax balances is quite common. I have them both in my own 401(k) plan.

For this reason, every 401(k) custodian that offers a Roth option also needs to have a methodology of rolling over the funds from different sections of the plan to different account types. Although this issue feels complex, it is actually solved by often simple paperwork.

The paperwork normally has a “Check which Source(s) You’d Like to Rollover” portion where you check off which components of the 401(k) you’d like to go to the listed IRA.

Many employer-sponsored plans offer an employer match (sometimes called an “Employer Safe Harbor Match”) and/or profit sharing (“Employer Profit Sharing”). These types of accounts are always traditional assets and should be moved to a Rollover IRA. Usually, if the word “employer” is in the plan portion, that is a cue that the portion of the plan is pre-tax.

When it comes to employee deferrals, many employer plans offer both Roth and traditional deferral options. If you have ever switched funding options, you may have some assets in each type of account. In my 401(k) plan, these two accounts are called “Employee Deferrals” and “Roth 401(k) Account.” Roth deferrals (the “Roth 401(k) Account” in my plan) should be rolled over into a Roth IRA. Traditional deferrals (the “Employee Deferrals” in my plan) should be rolled over into a Rollover IRA.

If your plan allows for in-service Roth conversions, you likely have a Roth conversion portion of the plan (“In-Plan Roth Conversion” in my plan). This should be rolled over into a Roth IRA.

If your plan allows for roll-ins (consolidating an old employer’s 401(k) into your current employer’s), then you also might have a rollover portion of the plan like the “Pre-Tax Rollover Account” in my plan. The “pre-tax” in the title tells you that these are traditional assets that should be rolled over into a Rollover IRA.

You may have more components than my plan, or they may be called different things. It is important that you know what each component of your employer plan is before proceeding with the rollover.

You are allowed to move your Traditional 401(k) assets into a Roth IRA, but the IRS will consider this a Roth conversion and tax you on it. Furthermore, as of 2018, this type of conversion cannot be undone.

You are allowed to move your Roth 401(k) assets into an IRA Rollover, but the IRS will consider this a nondeductible contribution and subject it to the “coffee and cream rules.”

As a result, confirm that you move pre-tax traditional assets into a Rollover IRA and post-tax Roth assets into a Roth IRA. If you need assistance, don’t be afraid to ask for it.

The IRS guidelines for rollovers dedicate a lot of prose to how rollovers “sent to multiple destinations at the same time are treated as a single distribution.” This can be confusing for people. These rules are due to the confusing way that the IRS thinks about rollovers.

The IRS assumes that you will perform what is called a “rollover contribution” even though this alternate rollover process is riddled with many rules and potential landmines. In a rollover contribution, one account distributes a check for all of the assets it holds. Then, within the allowed time period of 60 days, you deposit that check into a different retirement account. Because you are only allowed to perform this type of rollover once per year, the IRS needs to give you permission to perform rollovers to multiple destinations during your once per year in case this is the methodology you choose.

In reality, the easiest and cleanest way to accomplish an IRA Rollover is through what is called a trustee-to-trustee transfer or a direct rollover. A direct rollover is when the funds move directly from one account to the other without the owner ever having control of the funds.

If your 401(k) custodian refuses to perform a trustee-to-trustee transfer and insists on writing a check, then you can still perform a direct rollover by getting them to make the check out to your IRA account (for example “John Smith IRA, Charles Schwab Account 1234-5678”) rather than to you personally. This will protect you from the landmines of the rollover contribution.

All of this is to say if you are worried about starting Roth contributions, ask your 401(k) custodian to see the paperwork you’d need to use to do a rollover. If it is not clear, ask them in advance, questions like “How do I fill out the form to rollover my Roth funds to a separate location than my traditional funds?” The methodology of doing this should be easily doable. If it is not, consider telling your employer that your 401(k) custodian is not providing a good service to employees. The plan sponsor is held to the fiduciary standard and should take your concerns seriously.

After clearing your worries, you should be able to start building your Roth balances in your 401(k) plan!

If you are or would like to become a “Do-It-Yourself” client of Marotta Wealth Management, you may enjoy reading our guide “How to Rollover Your 401(k) into a Schwab Institutional Intelligent Portfolio with Marotta Wealth Management.”

Photo by Engin Akyurt from Pexels

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine

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