Understand the Pro-Rata Rules
You can roll an entire 401(k) into a Traditional IRA, including both pre-tax and after-tax (non-Roth) contributions. However, doing so without a plan can create unnecessary tax complications.
For example, suppose a client has $500,000 in pre-tax funds and $500,000 in after-tax contributions. If the entire $1 million is rolled into a Traditional IRA, subsequent distributions are generally subject to the pro-rata rules. Assuming the after-tax basis is properly documented, a $10,000 distribution would be $5,000 taxable and $5,000 tax-free.
The lesson? Understand what is in the account before initiating the rollover.
Always Ask These Four Questions
Before moving any money, have your team contact the 401(k) custodian to determine the available options.
1. Is there a Roth portion?
Roth funds can generally be rolled into a Roth IRA, preserving their appropriate tax treatment.
2. Are there after-tax, non-Roth contributions?
Depending on the plan, these contributions can generally be rolled into a Roth IRA, while associated pre-tax earnings may go into a Traditional IRA. If the client needs cash, a distribution of the after-tax basis may also be an option. Coordinate the transaction carefully with the custodian.
3. Is there a pre-tax portion?
Pre-tax funds can generally be rolled into a Traditional IRA. If a Roth conversion is part of the plan, I often prefer moving the funds into the Traditional IRA first and then handling the conversion separately. This provides greater control over the timing and amount converted.
4. Is there employer stock that may qualify for Net Unrealized Appreciation (NUA) treatment?
If the client owns publicly traded employer stock in their 401(k), stop before initiating the rollover.
Under qualifying circumstances, the stock may be distributed in kind to a taxable brokerage account. The cost basis is generally taxed as ordinary income upon distribution, while qualifying net unrealized appreciation may receive long-term capital gains treatment when the stock is sold.
The rules are complex, and specific requirements apply. If you identify a potential NUA opportunity, call me before moving forward.
The Takeaway
A 401(k) rollover is not always as simple as moving money from one account to another. Different types of contributions have different tax implications, and the right strategy can make a meaningful difference.
Before initiating a rollover, ask about Roth funds, after-tax contributions, pre-tax funds, and employer stock.
One simple question to ask prospects:
“Does your 401(k) contain a mix of pre-tax, Roth, and after-tax contributions, or do you own company stock in the plan?”
You might uncover a planning opportunity that others overlook—and demonstrate that you're looking beyond the account balance to the bigger tax picture.
