The Process for Withdrawing After-Tax 401(k) Contributions

After-tax 401(k) contributions represent a savings avenue within some employer-sponsored retirement plans. This option is for individuals who have already reached their annual contribution limits for standard pre-tax or Roth 401(k)s but wish to continue saving for retirement. The primary appeal is the ability to accumulate more funds within a tax-advantaged structure, but accessing these funds is governed by a distinct set of rules.

Components of an After-Tax 401(k) Account

An after-tax 401(k) account consists of two distinct financial components. The first is the after-tax contributions, which are funds you deposit from your paycheck after income taxes have been paid. This amount is referred to as the “basis,” and since it has already been taxed, it can be withdrawn tax-free. This basis is tracked separately by your plan administrator.

The second component is the investment earnings that accumulate on your contributions. This growth, which can come from dividends, interest, or capital gains, is tax-deferred, meaning you do not pay taxes on the earnings as they accumulate. However, these earnings will be subject to ordinary income tax when you withdraw them.

It is necessary to distinguish after-tax 401(k) contributions from Roth 401(k) contributions. While both are funded with post-tax dollars, their earnings are treated differently. With a Roth 401(k), both contributions and earnings can be withdrawn completely tax-free in retirement, provided certain conditions are met. In contrast, only the contributions in an after-tax 401(k) are tax-free upon withdrawal, while the earnings are taxable.

Tax Rules for Withdrawals

Withdrawals from an account with after-tax 401(k) funds are governed by the pro-rata rule. Under Section 72 of the tax code, the IRS stipulates that any distribution must consist of a proportional blend of your tax-free contributions and your taxable earnings. You cannot choose to withdraw only the tax-free contributions and leave the taxable earnings in the plan. This is sometimes called the “cream in the coffee” rule, as the components cannot be easily separated for a simple withdrawal.

To illustrate, consider an after-tax 401(k) account with a total balance of $10,000, composed of $8,000 in contributions and $2,000 in earnings. Here, 80% of the account is basis and 20% is earnings. If you were to withdraw $5,000, the pro-rata rule dictates that 80% ($4,000) would be a tax-free return of your contributions, while the remaining 20% ($1,000) would be taxable earnings.

An additional tax consideration is the 10% early withdrawal penalty. If you are under age 59.5, this penalty applies to the taxable portion of the distribution. In the previous example, the 10% penalty would be assessed only on the $1,000 of earnings, resulting in a $100 penalty. The plan administrator is responsible for calculating the taxable portion of any withdrawal, which is then reported to you and the IRS.

Strategic Withdrawal and Rollover Options

An in-service withdrawal allows you to take a cash distribution while still employed, if your plan permits it. This type of withdrawal is subject to the pro-rata rule and the potential 10% early withdrawal penalty.

A more tax-efficient approach uses rollovers to separate contributions from earnings. IRS Notice 2014-54 provides guidance that allows for splitting a distribution into multiple destinations. This means you can direct the different components of your after-tax 401(k) account to different retirement accounts simultaneously. This strategy is central to the “mega backdoor Roth” process.

The common strategy is to roll over the after-tax contributions directly to a Roth IRA, which is a tax-free event. Concurrently, the pre-tax earnings from the after-tax 401(k) can be rolled over to a Traditional IRA. This second rollover is also tax-free at the time of the transaction and defers income tax on the earnings until you take distributions from the Traditional IRA.

By moving the basis to a Roth IRA, all future investment growth on those funds becomes permanently tax-free. To execute this, you must take a full distribution of the after-tax account balance and direct the plan administrator to send the funds to the designated Roth and Traditional IRAs.

The Withdrawal and Tax Reporting Process

To initiate a withdrawal or rollover, you must first contact your 401(k) plan administrator. They will provide the necessary forms and outline the specific procedures for your plan. You will need to specify the type of transaction and provide the account details for the receiving financial institutions for a rollover.

After the transaction, your plan administrator sends IRS Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” Box 1 shows the gross distribution amount, Box 2a shows the taxable portion, and Box 5 will show the non-taxable amount (your basis).

The codes in Box 7 of Form 1099-R describe the nature of the distribution. A “Code G” indicates a direct rollover to a qualified plan or Traditional IRA. If you roll after-tax funds to a Roth IRA, the administrator might use “Code H”. Understanding these codes helps ensure your transaction is reported correctly.

When you file your federal income tax return, you will use the information from Form 1099-R to report the transaction on Form 1040. The total distribution from Box 1 is reported on line 5a, and the taxable amount from Box 2a is reported on line 5b. If you completed a rollover, you write “ROLLOVER” next to line 5b.

If you roll after-tax funds into a Traditional IRA, you must file Form 8606, “Nondeductible IRAs,” to track your basis. This ensures those funds are not taxed again upon future withdrawal.