10% Early Withdrawal Tax on Non-Roth After Tax

[Guest BWNWE]

A participant in the 401(k) Plan at the Company where I work has contacted the Plan record keeper regarding a distribution of his non-Roth after-tax contributions.

He indicated to the operator that the portion attributable to earnings would be rolled over to a Traditional IRA while the contributions would be used to pay for some expenses. The operator told him that the 10% tax on early withdrawals would apply to the contributions. I've seen this reaffirmed by many sources. However, here is the specific language from the IRS website:

"Tax on early distributions. If a distribution is made to a participant before he or she reaches age 59½, the participant may be liable for a 10% additional tax on the distribution. This tax applies to the amount received that the employee must include in income."

So according the IRS website, I don't think what the operator is indicating is correct because...the after-tax portion was included in the participant's income in the various years in which he made such contributions. Therefore, it would not be included in his income this year.....

P.S. I won't be sharing this information with the participant, obviously, as a Plan Fiduciary it could be construed as giving financial advice. Just wanted to clarify.

[ETA Consulting LLC]

Stating a rule is not giving advice. Many people who are unaware of the rules will use "we don't give tax advice" as a cop out. You pay the 10% penalty "ONLY" on amounts that are "TAXABLE". Since the after-tax contribution basis is not "TAXABLE", there would be no 10% early withdrawal penalty.

NOW, Keep in mind this is in reference to non-Roth after-tax employee contribution amounts.

Good Luck!

[masteff]

See your 402(f) (aka "Special Tax") notice.

I'm not sure if it's the absolute latest version but from Notice 2009-68:

"SPECIAL RULES AND OPTIONS

If your payment includes after-tax contributions

After-tax contributions included in a payment are not taxed. If a payment is only part of your benefit, an allocable portion of your after-tax contributions is generally included in the payment. If you have pre-1987 after-tax contributions maintained in a separate account, a special rule may apply to determine whether the after-tax contributions are included in a payment.

You may roll over to an IRA a payment that includes after-tax contributions through either a direct rollover or a 60-day rollover. You must keep track of the aggregate amount of the after-tax contributions in all of your IRAs (in order to determine your taxable income for later payments from the IRAs). If you do a direct rollover of only a portion of the amount paid from the Plan and a portion is paid to you, each of the payments will include an allocable portion of the after-tax contributions. If you do a 60-day rollover to an IRA of only a portion of the payment made to you, the after-tax contributions are treated as rolled over last. For example, assume you are receiving a complete distribution of your benefit which totals $12,000, of which $2,000 is after-tax contributions. In this case, if you roll over $10,000 to an IRA in a 60-day rollover, no amount is taxable because the $2,000 amount not rolled over is treated as being after-tax contributions.

You may roll over to an employer plan all of a payment that includes after-tax contributions, but only through a direct rollover (and only if the receiving plan separately accounts for after-tax contributions and is not a governmental section 457(b) plan). You can do a 60-day rollover to an employer plan of part of a payment that includes after-tax contributions, but only up to the amount of the payment that would be taxable if not rolled over."

[Guest BWNWE]

Thanks for the replies. You've confirmed my suspicions that a participant can indeed rollover the pre-tax earnings portion of the distribution to an IRA.

As far as giving advice, I agree, stating an IRS rule doesn't constitutue giving advice. However, when I state that rule the next question is "Well, is this taxable income?"--sorry, but in this litiguous society, that't getting a little bit to close to going down the path of giving advice. You can't state that rule without going down the path of interpreting the law and that is giving financial advice.

Example: The Company modified eligibility for post retirement medical benefits two years ago. There was a window where employees could retire at 50w/ five years of service and receive a Company contribution toward premiums starting at 55. At 1/1/11, you had to be 60 w/ 20 to be eligible to retire and to get a contribution. So one person called, stated her intention to retire to me and said she wanted to defer pension benefit payments--no problem. She then asked me about her 401(k) and eligibility to take a distribution. I told her that, if you terminated employment in the year that you attained 55 (she was 54 in 2010) that you could receive a distribution w/out the 10% early withdrawal penalty.

I emphasized terminated employment in the year you attain age 55 and that she was terminating 12/31/10...she did not attain 55 in 2010 but in 2011. She went to a finacial advisor and the advisor simply took what I said and told her "no penalty, no problem". She retired effective 1/1/11, terminated 12/31/10. She took a withdrawal from Fidelity....and had to pay the 10% tax. I ended up with the DOL/ESA all over my backside. Lesson learned.

[ETA Consulting LLC]

As far as giving advice, I agree, stating an IRS rule doesn't constitutue giving advice. However, when I state that rule the next question is "Well, is this taxable income?"--sorry, but in this litiguous society, that't getting a little bit to close to going down the path of giving advice. You can't state that rule without going down the path of interpreting the law and that is giving financial advice.

I can appreciate what you're saying. Each financial professional has their own line. Some lines move a little further down the road without constituting advice. Eventually, it becomes an issue of training and comfort. In all instances, however, never hesitate to seek the opinion of others when you're not comfortable.

Good Luck!