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Author: futuretrust Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 74759  
Subject: 401K - another option Date: 8/25/1998 12:38 AM
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I have been investing in my 401K and it's SP500 index fund for a number of years and it has served me very well. However, I really enjoy analyzing and selecting stocks for myself, but I can't with my current 401K plan. I don't plan on leaving my job anytime soon, so I did a little investigating and came up with a plan that might allow me to get some money out of my 401K without losing the company matching funds of 50 cents on the dollar. I thought I would run it by you folks to make sure it is foolproof.

I realize I can't touch my existing 401K pre-tax funds until I leave the plan, but I will start making my future 401K contributions after-tax instead of pre-tax. My company continues to match after-tax contributions. With my modest salary and wife home with kids, I am in the 15% tax bracket for the foreseeable future. Since I hope to be withdrawing this money at retirement at a much higher rate it makes sense from a tax standpoint. I've done the spreadsheeets.

Once a year, I will withdraw my after-tax 401K contributions and associated gains for the previous year. I will roll the gains over into an existing IRA with a discount broker and I will take the after-tax contributions and put as much as I can into a Roth IRA for myself and my wife. Because of the $4,000 maximum, whatever is left over will be invested in my normal discount brokerage account. As a buy and hold investor I should be able to get the 8% Cap Gains tax quite often (assuming I can get some Cap Gains!).

My company matching contributions on after-tax contributions can not be withdrawn, so it will be added to my pre-tax 401K funds and invested in the SP500 or other fund of my choice.

I have verified with my plan that there are no restrictions on after-tax withdrawals and that the company matching contributions are not suspended for such withdrawals. The only drawback I have found is a $10 withdrawal fee. I think I can handle that once a year.

I see the benefits as threefold:
-more tax efficient.
-satisfies my desire to buy foolish stocks.
-continue receiving company matching "free money"

There it is! I am counting on you folks to point out the faults in my plan and where I might be making some bad assumptions.

One final concern is that I feel a little uneasy about what I'm doing. Sort of like cheating the system. If everyone did this, then my plan would probably place restrictions on this activity. Is this warranted?
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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5162 of 74759
Subject: Re: 401K - another option Date: 8/25/1998 11:21 AM
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Greetings, Futuretrust, and welcome.

… I don't plan on leaving my job anytime soon, so I did a little investigating and came up with a plan that might allow me to get some money out of my 401K without losing the company matching funds of 50 cents on the dollar. I thought I would run it by you folks to make sure it is foolproof.

I realize I can't touch my existing 401K pre-tax funds until I leave the plan, but I will start making my future 401K contributions after-tax instead of pre-tax. My company continues to match after-tax contributions. With my modest salary and wife home with kids, I am in the 15% tax bracket for the foreseeable future. Since I hope to be withdrawing this money at retirement at a much higher rate it makes sense from a tax standpoint. I've done the spreadsheeets.

Once a year, I will withdraw my after-tax 401K contributions and associated gains for the previous year. I will roll the gains over into an existing IRA with a discount broker and I will take the after-tax contributions and put as much as I can into a Roth IRA for myself and my wife. Because of the $4,000 maximum, whatever is left over will be invested in my normal discount brokerage account. As a buy and hold investor I should be able to get the 8% Cap Gains tax quite often (assuming I can get some Cap Gains!).

My company matching contributions on after-tax contributions can not be withdrawn, so it will be added to my pre-tax 401K funds and invested in the SP500 or other fund of my choice.

I have verified with my plan that there are no restrictions on after-tax withdrawals and that the company matching contributions are not suspended for such withdrawals. The only drawback I have found is a $10 withdrawal fee. I think I can handle that once a year.

I see the benefits as threefold:
-more tax efficient.
-satisfies my desire to buy foolish stocks.
-continue receiving company matching "free money"

There it is! I am counting on you folks to point out the faults in my plan and where I might be making some bad assumptions.

One final concern is that I feel a little uneasy about what I'm doing. Sort of like cheating the system. If everyone did this, then my plan would probably place restrictions on this activity. Is this warranted?


Such a fine plan, and so eloquently stated. However, it won't work quite the way you have outlined. First, you can withdraw up to a maximum of your after-tax contributions only. Technically, no gains may be taken. Second, while you may withdraw those after-tax contributions, they will not come back to you tax-free. Instead, the IRS requires part of your withdrawal to be considered as a distribution of previously untaxed money based on the ratio of your after-tax contributions to the market value of your account at the time of withdrawal. Let's look at a quick example.

You have $1K in after-tax contributions in an account worth $5K. You withdraw $1K, the maximum permitted based on your after-tax contributions. The ratio of your after-tax contributions to the market value is 20% ($1K divided by $5K). The IRS will say that the $1K you took is composed of $200 in after-tax money (0.2 times $1K) and the remaining $800 of the distribution is pre-tax money. You will be taxed on that $800 at ordinary rates and penalized an additional 10% (or $80) because you are younger than age 59 ½ at the time of withdrawal. (Note: Subsequent withdrawals from your 401k will be based on $800 of remaining after-tax contributions.)

The good news is you can avoid income taxes and the penalty by having the taxable part of the withdrawal, or $800, transferred to a traditional IRA. The bad news is unless you can arrange for a direct transfer of that $800 from the plan to the IRA, then 20% of that amount will be withheld for potential taxes. That 20% must be added from other resources to your net proceeds to ensure you roll 100% of that $800 to the IRA. The good news is after the money is in the traditional IRA, you can then transfer it to a Roth IRA. The bad news is when you do you must pay taxes on the sum transferred to the Roth. The good news is the conversion to a Roth will avoid the 10% early withdrawal penalty.

Ultimately, then, you get to do what you want to do. It just will be a complicated drill assuming you wish to avoid any penalty. The taxes you won't avoid.

Regards…..Pixy


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Author: DIL Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5184 of 74759
Subject: Re: 401K - another option Date: 8/25/1998 8:54 PM
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I am confused. I am told by my plan administrator the following:

I can withdraw before tax contributions but I also must withdraw the associated gains on those contributions as well.
I will have to pay a 10% early withdrawal penalty on only the gains. I will have to pay a 20% tax on only the gains.
I can avoid both the tax and penalty by rolling the gains over to a qualified IRA.
If I do this I can do with the before tax contributions as I please.

He is sending me a publication that he says will confirm this.

Puzzled



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Author: Rayvt Big gold star, 5000 posts Top Favorite Fools Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5187 of 74759
Subject: Re: 401K - another option Date: 8/25/1998 11:19 PM
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<<Once a year, I will withdraw my after-tax 401K contributions and associated gains for the previous year. I will roll the gains over into an existing IRA with a discount broker and I will take the after-tax contributions and put as much as I can into a Roth IRA for myself and my wife>>

I suspect that this is too clever by half. And, AFAIK, withdrawals from a 401(k) are taxed as ordinary income PLUS 10% penalty. Somehow I doubt that the IRS has left a loophole in the rules, such that this plan would work.

Why not just put in enough to get the full employer match? Most only match up to a certain percentage of your salary---you imply that your employer does a 50% match for everything you put in. If so, this is unusually generout---I'd verify this carefully.

The balance (what you are putting in that is not getting matched), just put into your IRA and/or ordinary account.

Ray



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Author: Rayvt Big gold star, 5000 posts Top Favorite Fools Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5188 of 74759
Subject: Re: 401K - another option Date: 8/25/1998 11:25 PM
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<<The good news is you can avoid income taxes and the penalty by having the taxable part of the withdrawal, or $800, transferred to a traditional IRA. The bad news is unless you can arrange for a direct transfer of that $800 from the plan to the IRA, then 20% of that amount will be withheld for potential taxes. That 20% must be added from other resources to your net proceeds to ensure you roll 100% of that $800 to the IRA. The good news is after the money is in the traditional IRA, you can then transfer it to a Roth IRA. The bad news is when you do you must pay taxes on the sum transferred to the Roth. The good news is the conversion to a Roth will avoid the 10% early withdrawal penalty.>>

As I said, "Too clever by half."

Ya gotta look at the whole picture, too. Is the game worth the candle? If you are in the 15% bracket, you are already paying pretty low taxes. The actual numbers of dollars you will save with all these complicated gyrations is probably pretty small.

Ray


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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5191 of 74759
Subject: Re: 401K - another option Date: 8/26/1998 8:09 AM
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Dear Puzzled: (Note: Kinda like an Ann Landers or advice to the lovelorn column ain't it?)

You said:

I am confused. I am told by my plan administrator the following:

I can withdraw before tax contributions but I also must withdraw the associated gains on those contributions as well.
I will have to pay a 10% early withdrawal penalty on only the gains. I will have to pay a 20% tax on only the gains.
I can avoid both the tax and penalty by rolling the gains over to a qualified IRA.
If I do this I can do with the before tax contributions as I please.

He is sending me a publication that he says will confirm this.


It's not surprising you're somewhat confused because this isn't the easiest of areas to understand. Also, the terminology seems to have you somewhat mystified. Let's start with the easy definition first. The "20% tax" to which you refer isn't a tax at all. It's a withholding or prepayment of potential taxes based on the increased income any distribution from the 401k plan may create. In that sense, it's no different than the withholding that's deducted from your paycheck every pay period. The actual tax payable on the distribution will be determined as part of your total tax bill for the year based on the total of all your taxable income, of which the 401k distribution may be just a part. If you transfer the taxable distribution in its entirety to an IRA, that distribution won't be counted as part of your income and it won't be taxed at all. In that case, the 20% withholding will be returned to you or will serve to reduce any taxes you still have to pay at the end of the year.

Let's now look at the issue of "gains." Your administrator is using that term in its broadest sense. In reality, the taxable part of any distribution consists of any contributions that were never taxed (i.e., your pre-tax contributions and those made by your employer) and any gains on the funds deposited to the account.

Remember the example I used in response to Futuretrust's query: Your after-tax contributions are $1K, and the total market value of the account is $5K. Well, that $5K consists of your after-tax deposits, your pre-tax deposits, your employer's contributions, and any gain on all deposits since they were made. The last three items have never been taxed, but your after-tax contributions have. You may take your after-tax contributions at any time, and they are yours free of tax to do with what you want save they cannot be transferred to an IRA. The hooker, though, is as I stated in my original post. If you take a distribution from your 401k, you can't just take after-tax money. Under existing law only part of that distribution will be free of taxes and penalty. The rest is subject to tax and possibly the 10% early withdrawal penalty as well.

O.k., with all the above as a given let's say you decide to take $1K from your 401k. The part of that distribution that returns to you tax-free is computed based on the ratio of your after-tax contributions ($1K) to the market value of the account ($5K). That means 20% is tax-free ($1K / $5K), or $200 ($1K X 0.2). The rest, or $800 ($1K - $0.2K), is subject to taxes and penalty. (Note: This $800 is not "gain" per se. Instead, it is money that has never been taxed before, and that consists of the three items cited above.) Future tax-free withdrawals from the 401k will be computed the same way except the next one will say your after-tax basis is only $800 because you already received $200 in the first distribution.

If the distribution is sent to you, then by law the plan must withhold 20% of that $800, or $160 (0.2 X $800) for potential taxes due. That means you will get a check for $840 ($1K - $160) of which $200 is yours to keep and $640 is taxable. If you keep that $640, it along with the $160 withholding (total of $800) will be included in your income for the year and taxed. Additionally, you'll be zapped an additional 10%, or $80 (0.1 X $800), as an early withdrawal penalty. To avoid that, you must roll the $640 to an IRA within 60 days. Additionally, you must add another $160 from other assets to the rollover to ensure the entire $800 distribution escapes taxes and penalty. If you don't, the IRS will say that $160 withheld is a fully taxable distribution. It will be included in your income for the year and taxed. It will also be assessed the 10% early withdrawal penalty, or $16.

Clear? If not, just ask again.

Regards…..Pixy


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Author: futuretrust Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5195 of 74759
Subject: Re: 401K - another option Date: 8/27/1998 12:16 AM
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I now understand how my withdrawal will be distributed as pre-tax and after tax. So, my next question would be what happens at the next withdrawal? Using your example, let's say a year passes and I contribute another $1,000 after-tax. My account total is now worth $6,000 (it was a good year!). I make another withdrawal. Based on what you said above, does this mean I can withdraw $1,800 (My after-tax contribution $1,000 plus the left over $800 from the previous withdrawal)? Or is the $800 just used for computing the ratio of pre-tax to after-tax and the maximum I can withdraw is $1000. If I can use the $800 left over, this would be very good news. Since my after-tax contributions will be a very small percentage of my total account value, this will allow me to withdraw even more money going forward.

Either way I will be able to get some money out of the 401K and into a traditional IRA without penalty. I am almost certain I can do a direct transfer. This will allow me to add a stock or two to the portfolio each year :-) and depending on the answer to the question above maybe a few more. As far as rolling over into a Roth IRA, I'm sure it makes sense from a tax efficiency standpoint. However, I've already increased my tax bill by going after-tax with my contributions. I assume when you roll an IRA into a Roth IRA the tax must be paid out of pocket as opposed to reducing the account value. Maybe I'll do a portion of what I can handle on a yearly basis. We do have the child tax credit coming, so that will help.

As far as the question of "is this all worth it?", for most people, probably not. But for someone who wants to get some of their 401K money into individual stocks, this works. Also, because of the after-tax contributions, it helps to be in the 15% tax bracket and have a high aspiration for a lofty retirement income. I wish my employer's 401K allowed individual stock accounts. Since they don't, this is the price I must pay.

Thank You for your insight, you were quite helpful.

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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 5197 of 74759
Subject: Re: 401K - another option Date: 8/27/1998 8:08 AM
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Futuretrust asks in a follow-up post:

I now understand how my withdrawal will be distributed as pre-tax and after tax. So, my next question would be what happens at the next withdrawal? Using your example, let's say a year passes and I contribute another $1,000 after-tax. My account total is now worth $6,000 (it was a good year!). I make another withdrawal. Based on what you said above, does this mean I can withdraw $1,800 (My after-tax contribution $1,000 plus the left over $800 from the previous withdrawal)?

That's exactly what it means. However, note that in this case your tax-free distribution will be computed on the ratio of $1.8K to $6K meaning 30% ($540) now comes back tax free, and the rest must be rolled to an IRA. After that withdrawal your basis becomes $1,800 less $540 plus any new after-tax deposits for subsequent withdrawals.

Either way I will be able to get some money out of the 401K and into a traditional IRA without penalty. I am almost certain I can do a direct transfer.

Just one word of caution here: Ensure your plan will clearly define the taxable and non-taxable distribution at the time of withdrawal. After-tax money cannot be transferred to the IRA, so one check for that money must come to you and another for the taxable part must be sent to the IRA custodian for deposit into your IRA.

This will allow me to add a stock or two to the portfolio each year :-) and depending on the answer to the question above maybe a few more. As far as rolling over into a Roth IRA, I'm sure it makes sense from a tax efficiency standpoint. However, I've already increased my tax bill by going after-tax with my contributions. I assume when you roll an IRA into a Roth IRA the tax must be paid out of pocket as opposed to reducing the account value. Maybe I'll do a portion of what I can handle on a yearly basis. We do have the child tax credit coming, so that will help.

Well, a rollover to a Roth might make sense, but it's not a sure thing. How you pay any taxes due will certainly play a big part. If you have to use part of the conversion money to do so, then the option becomes less attractive. You will have to run the numbers at the time to ensure the move is a good one for you. For an idea of some of the issues involved, see my previous posting on the subject at: http://boards.fool.com/Registered/Message.asp?id=1040013000441002&sort=postdate .

As far as the question of "is this all worth it?", for most people, probably not. But for someone who wants to get some of their 401K money into individual stocks, this works. Also, because of the after-tax contributions, it helps to be in the 15% tax bracket and have a high aspiration for a lofty retirement income. I wish my employer's 401K allowed individual stock accounts. Since they don't, this is the price I must pay.

LOL. Keep those aspirations high, and come retirement you'll be in great shape. Just ensure you do the required analyses along the way so everything fits in with your goals and plans.

Regards……Pixy


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Author: DIL Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 6137 of 74759
Subject: Re: 401K - another option Date: 10/20/1998 9:28 PM
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Sorry to bother you again Pixy. But again I must reiterate that on more than one occasion my plan administrator (State Street)has told me that I can withdraw my after tax contributions free and clear (no tax or penalty) and that I can roll over the gains on the after tax contributions into an IRA without penalty or taxes (they will do this for me, the rollover that is). It might be worth noting that the plan provides for separate "accounts" for the pre tax and after tax monies and show the contributions and gains attributed to each.

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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 6164 of 74759
Subject: Re: 401K - another option Date: 10/21/1998 12:43 PM
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DIL worte:

Sorry to bother you again Pixy. But again I must reiterate that on more than one occasion my plan administrator (State Street)has told me that I can withdraw my after tax contributions free and clear (no tax or penalty) and that I can roll over the gains on the after tax contributions into an IRA without penalty or taxes (they will do this for me, the rollover that is). It might be worth noting that the plan provides for separate "accounts" for the pre tax and after tax monies and show the contributions and gains attributed to each.

You may indeed withdraw your after-tax contributions to a 401k. When you do, IRS rules stipulate that the withdrawal will be composed of partly taxable and partly untaxed money. When separate accounting is used for after-tax contributions, a special formula is used to determine how much of the 401k balance is attributed to your after-tax contributions and the earnings thereon. You may then withdraw that amount. The previously taxed portion (your contributions) is yours to keep and cannot be rolled to an IRA. The rest (the earnings) will be taxed and penalized unless transferred to an IRA.

Regards….Pixy


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Author: DIL Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 9917 of 74759
Subject: Re: 401K - another option Date: 4/13/1999 1:25 AM
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Pixy I need your help again, I sent a similar post to TMF Taxes because I thought it was he was the TMF that I had the dialog with.

In any event, after withdrawing my after tax contributions and rolling the gains over to my IRA (and investing both foolishly) I now have to fill in my 1040 (better late than never).

I am having difficulty doing this. since they want you to use form 8606, but when I try to fill in, it makes no sense. It seems to lead you down the path that you originally were taking ie some proportional thing.

I am prety sure I do not owe taxes how do I fill in my 1040 to show this???

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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 9921 of 74759
Subject: Re: 401K - another option Date: 4/13/1999 8:48 AM
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DIL writes:

<<Pixy I need your help again, I sent a similar post to TMF Taxes because I thought it was he was the TMF that I had the dialog with.

In any event, after withdrawing my after tax contributions and rolling the gains over to my IRA (and investing both foolishly) I now have to fill in my 1040 (better late than never).

I am having difficulty doing this. since they want you to use form 8606, but when I try to fill in, it makes no sense. It seems to lead you down the path that you originally were taking ie some proportional thing.

I am prety sure I do not owe taxes how do I fill in my 1040 to show this??? >>


The distribution you received was from a 401k plan, not an IRA. Form 8606 is used to report information on IRAs, not retirement plans. Thus I'm puzzled why you are even messing with it for this distribution. You don't use Form 8606 for this purpose. Just show the total distribution as shown on your Forms 1099R on Line 16a of the Form 1040. To show the rollover, enter the number zero on line 16b. Write the word "Rollover" next to Line 16b. Attach your Forms 1099R to your return. That's all that's required. For details, see pages 22 through 24 of the instructions to Form 1040. They are available at www.irs.gov.

Regards..Pixy

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