One of my clients has a 401(k) plan which also permits after-tax contributions. Traditionally, participants separating from service and seeking to avoid taxes would elect to roll over 100% of the distribution to an IRA. The plan administrator would segregate the after-tax contributions, roll over the remaining amounts, and issue a check (non-taxable) for the amount of the after-tax contributions only. Great result--some cash for the separating participant, no taxable event.

Following the new rollover rules for 2002, the administrator is now rolling over the entire distribution, including the after-tax contributions. The IRA custodian is saying that the 10% penalty tax applies to a pre 59.5 withdrawal of these after-tax contributions. This doesn't seem right to me, but I'll be the first to admit that I don't have a lot of IRA experience. I'd appreciate any insight that could be offered, as well as any cites or links that might be appropriate.

Thanks in advance for the help.

While the new law permits the rollover of after tax amounts, the 10% penalty only applies to any amount that is included in income. Since no part of the distribution of after tax amounts would be included in income, no 10% penalty is imposed.

For the record, ignorant custodians who spout misinformation really P*SS ME OFF!

Thanks Barry. That makes lots of sense to me. I'll inform my client.