After-Tax 401k Withdrawal

How does an after tax 401k withdrawal work?

If, at any point, you’ve made after-tax contributions to your 401k plan, then you have the opportunity to take a withdrawal of those assets should the need arise.

Note: We want to make the distinction early on. After-tax 401k withdrawals are different than Roth 401k withdrawals.

While taking any withdrawal from your 401k plan should be the furthest thing from your mind, withdrawing after tax assets eases the potential tax burden quite a bit, and should be your number one option if you have no choice but to tap your account.

The benefits of an after tax 401k withdrawal are plainly obvious. You’ve already paid taxes on the money you have put into the account, so naturally when you withdraw it, you owe nothing else to Uncle Sam.

Another added benefit of an after tax 401k withdrawal is that you will not owe the IRS a 10% early withdrawal penalty for taking the distribution even if you are under the age of 59 ½. Sweet deal!

But wait…as always there’s a catch (you really didn’t think you were going to get away scot-free did you?). The IRS has a few tricks up its sleeve that you need to be aware of regarding the after tax 401k withdrawal.

Don’t forget that the after tax contributions you have made to the account have probably earned more money on it, right? If you invested properly, it did. And if you’ve been invested for quite some time, chances are the earnings are quite substantial. Well, these earnings have never been taxed before.

You probably see where we’re going with this, don’t you? Yup, Uncle Sam wants his cut of the earnings you made if you take that after tax withdrawal!

Back in the day, a plan participant could take an after tax withdrawal of just the principal value of his or her after tax dollars and not have to take any of the earnings, thus making the ENTIRE withdrawal non-taxable.

For example, let’s say that a participant made $10,000 in after tax contributions to their plan, and over time that $10,000 grew into $15,000. That same participant could take a withdrawal of $10,000 (the principal) and leave the $5,000 (earnings) untouched in the plan and ultimately pay no taxes and penalties on the entire $10,000 withdrawal.

Unfortunately, those days are long since gone! In 1986, Congress passed a sweeping legislative reform called the Tax Reform Act of 1986. This reform drastically changed many aspects of the way the taxes were handled in qualified plans(in fact, it’s this tax reform that we have to thank the 10% early withdrawal penalty for).

What the new law required was that any withdrawals made of after tax monies from a qualified plan must have a proportionate amount of earnings attached to them.

Let’s use the previous example of the participant with a $15,000 after tax balance in her account – $10,000 of which is principal (non-taxable) and $5,000 of which is earnings (taxable). Since the $5,000 in earnings represents one-third of the overall $15,000 balance, that means that any withdrawal she takes of after tax dollars must consist of roughly 33% in earnings. In other words, 33% of whatever withdrawal she takes will be subject to ordinary income tax AND a 10% early withdrawal penalty.

The 401k after tax withdrawal just lost its luster, huh?

Here is something important to note regarding after tax withdrawals, however: This new rule didn’t take affect until January 1st, 1987. So anyone who made after tax contributions prior to – and during – 1986, was grandfathered into the old rules while all after tax contributions made in 1987 and after followed the new rules.

What does this mean?

This means that if you happen to have after tax contributions that were made to your account in 1986 or before, you can take a withdrawal of just the principal amount and you won’t be required to include earnings with that. Any after tax contributions made after that you will be required to take a proportionate amount of earnings.

Your 401(k) record-keeper should be tracking your pre-1987 and post-1986 after tax contributions, so you should contact them to determine what your options are.