Penalty Tax on Pre 59.5 Withdrawal of Rolled A-Tax Contributions

[Jon Chambers]

One of my clients has a 401(k) plan which also permits after-tax contributions. Traditionally, participants separating from service and seeking to avoid taxes would elect to roll over 100% of the distribution to an IRA. The plan administrator would segregate the after-tax contributions, roll over the remaining amounts, and issue a check (non-taxable) for the amount of the after-tax contributions only. Great result--some cash for the separating participant, no taxable event.

Following the new rollover rules for 2002, the administrator is now rolling over the entire distribution, including the after-tax contributions. The IRA custodian is saying that the 10% penalty tax applies to a pre 59.5 withdrawal of these after-tax contributions. This doesn't seem right to me, but I'll be the first to admit that I don't have a lot of IRA experience. I'd appreciate any insight that could be offered, as well as any cites or links that might be appropriate.

Thanks in advance for the help.

[BPickerCPA]

While the new law permits the rollover of after tax amounts, the 10% penalty only applies to any amount that is included in income. Since no part of the distribution of after tax amounts would be included in income, no 10% penalty is imposed.

For the record, ignorant custodians who spout misinformation really P*SS ME OFF!

[Jon Chambers]

Thanks Barry. That makes lots of sense to me. I'll inform my client.