IRA Critical Mistake #2

You’ve been very careful with your 401k and IRA. You thought you did everything right. But ask yourself this:

Have you already made after-tax contributions to your 401k?

If your answer is yes, there’s a strong chance you’re making IRA Critical Mistake #2 in THE IRA CRITICAL MISTAKES series.

How so? Read on!

IRA Critical Mistake #2 is failing to consider a direct rollover of the 401k after-tax contributions you have already made to a Roth IRA.

To be clear, IRA Critical Mistake #2 discusses a strategy for 401k after-tax contributions you have already made. 

For strategies involving FUTURE 401k after-tax contributions, see IRA Critical Mistake #1.

What happens if you make IRA Critical Mistake #2? What do you risk losing if you make this mistake?

The consequence of making IRA Critical Mistake #2 is having to pay income tax someday on a portion of your 401k that otherwise could have grown and potentially become completely tax-free upon withdrawal.  

To understand this mistake, let’s first review some 401k facts:

• Every year the IRS limits the pre-tax contributions you can make to your 401k.  For 2025, the limit is $23,500 for those under 50, $31,000 for those ages 50-59 and 64 or older, and $34,750 for those ages 60-63.
  
  
• After reaching the annual IRS pre-tax contribution limit, many 401k plans allow additional after-tax contributions.  
  
  
• After-tax contributions can typically be withdrawn from your 401k without taxes or penalties while you are still working.  
  
  
• When 401k after-tax contributions are withdrawn, the earnings from the after-tax contributions must also be withdrawn. If these earnings are rolled over to a Traditional IRA, and proper IRS rollover rules are followed, current taxation can be avoided.  If these earnings are not rolled over, they are taxable and subject to the 10% IRS early withdrawal penalty if withdrawn before age 59 ½. 
  
  

Let’s look at a case study to see the income tax problem triggered by making IRA Critical Mistake #2.

• Over the years you make 401k after-tax contributions totaling $100,000• Over the years you make 401k after-tax contributions totaling $100,000
  
  
• $200,000 of earnings are generated from the $100,000 after-tax contributions
  
  
• 37% income tax bracket at the time of withdrawal
  
  
• After age 59 ½ you withdraw the $100,000 of after-tax contributions and the $200,000 of earnings
  
  

The $100,000 withdrawal of the after-tax contributions will be tax-free. The $200,000 withdrawal of earnings, however, will be fully taxable, triggering income taxes of 37% of $200,0000, or $74,000.

That’s a lot of tax. And that’s a problem.

Is there a strategy to avoid paying the income tax you will someday owe on future earnings generated from your 401k after-tax contributions?

There is.

The strategy is to roll over your existing 401k after-tax contribution balance to an outside Roth IRA by following these steps:

1. Open a new Roth IRA with the financial institution of your choice.
   
   
2. Open a new Traditional IRA with the financial institution of your choice.
   
   
3. Contact your 401k provider to do the following:
   
   
   1. Transfer your existing 401k after-tax contribution balance to your new Roth IRA via direct rollover.
   2. Transfer the existing balance of the earnings from the 401k after-tax contributions to your new Traditional IRA via direct rollover.
   3. Distributions from 401k’s are usually subject to a 20% mandatory tax withholding.  The direct rollover avoids the 20% mandatory tax withholding.
      
      
4. Because successfully implementing this strategy can be complex, and because of the possibility of triggering unnecessary or unexpected taxes, consult with your financial or tax advisor from the beginning of the planning phase through execution. 

Not surprisingly, few 401k participants follow this strategy because they are not familiar with the IRS tax code that allows for this strategy.

When you roll over after-tax contributions to a Roth IRA, all growth now takes place inside the Roth IRA. This means all growth in the Roth IRA may potentially be withdrawn tax-free, assuming IRS rules are followed for tax-free distributions from Roth IRA’s.

Move quickly. The sooner you roll over your 401k after-tax contributions to an outside Roth IRA, the sooner your funds may grow tax-fee!

• With your financial advisor or tax advisor, review your 401k plan document or contact your 401k provider to determine if you are a candidate for this strategy by finding out• With your financial advisor or tax advisor, review your 401k plan document or contact your 401k provider to determine if you are a candidate for this strategy by finding out
  
  
  • If 401k after-tax contributions are allowed
  • Your 401k after-tax contribution balance
  • The balance of the earnings on your 401k after-tax contributions
  • If the plan allows for the rollover of 401k after-tax contributions to a Roth IRA and the rollover of the earnings on the after-tax contributions to a Traditional IRA.
    
    
• IRA Critical Mistake #1 focuses on what to do with the 401k after-tax contributions you have already made. What about the 401k after-tax contributions you haven’t made yet? IRA Critical Mistake #1 focuses entirely on FUTURE 401k after-tax contributions.  For more on this important topic
  
  
  • Click Here to access IRA Critical Mistake #1: Not Considering Hyper-Funding your 401k Using In-Plan Roth Conversions
    
    
• Implementing this strategy may affect your eligibility to implement another potential tax strategy worthy of consideration called “Net Unrealized Appreciation.”  To learn more 
  
  
  • Click Here to access IRA Critical Mistake #3: Have Employer Stock in 401k?  Do This Before Rollover to IRA