Tuesday, July 3. 2012
Splitting After-Tax 401(k) Distributions For Roth Conversion
The inspiration for today's blog post is a series of inquiries I've received in recent months about the strategy of splitting pre- and after-tax 401(k) distributions, with the goal of completing a Roth conversion for the after-tax amount, while sending the pre-tax amount for an IRA. For example:
Sherry has a $100,000 401(k) that includes $20,000 of after-tax contributions. Her goal is to move the $20,000 of after-tax contributions to a Roth IRA as a tax-free Roth conversion (since after-tax funds are not taxable when withdrawn or converted), and the remaining $80,000 to a rollover IRA. In the end, the $20,000 Roth IRA will grow tax-free, and the $80,000 rollover IRA will be taxable in the future. Sherry intends to accomplish this by asking the employer to distribute the 401(k) in two checks: one for the after-tax amounts, which she will roll over to a Roth IRA (by having the check made payable directly to the Roth IRA as a trustee-to-trustee transfer), and the other check for the remaining (pre-tax) amounts which she will roll to her traditional IRA.If the accounts grow until they double, then in the future Sherry will have $40,000 of tax-free Roth funds, and $160,000 of taxable IRA investments. This is much better than the alternative, to simply roll over all $100,000 of the 401(k) to an IRA, which would result (after enough growth to double the account) in a $200,000 future IRA with $20,000 of non-deductible contributions, leaving Sherry with $180,000 of future taxable withdrawals. In the end, with the Roth conversion strategy Sherry has $160,000 of future taxable IRA growth, while with the "normal" rollover strategy, she has $180,000 of taxable IRA growth. Therefore, Sherry has saved $20,000 of future IRA taxable income, and the current tax cost was "nothing" since converting after-tax amounts to a Roth generates no current tax liability!
Technical Rules
Under IRC Section 402(a), distributions from employer retirement plans generally follow the rules of IRC Section 72 (or specifically, IRC Section 72(e)(8)), which states (with respect to qualified plans) that taxable distributions will be treated as including a pro-rata share of any "investment in the contract" (i.e., cost basis, or after-tax contributions).
If Sherry were to distribute $50,000, then 20% (or $10,000) of it would be non-taxable, because 20% of her total account ($20,000 / $100,000) is non-taxable.
On the other hand, the IRS Notice 2009-68 guidance does affirm that if Sherry receives a full distribution of the 401(k) plan (for which 20% mandatory withholding would also apply), then any rollovers that occur would be treated as coming from pre-tax amounts first, and after-tax amounts second. However, this treatment appears to only apply as long as Sherry keeps a portion of the funds. In other words, if Sherry receives a full $100,000 distribution, the first $80,000 of any rollover would be treated as pre-tax amounts first, and Sherry would be left with an after-tax balance of $20,000. Unfortunately, if Sherry then tries to convert the remaining $20,000 of after-tax funds to a Roth IRA within 60 days, the entire distribution will have been rolled over (since it would all have to occur within the same 60-day rollover period), which means the pro-rata rules apply once again!
Disagreements Still Abound
Notwithstanding the guidance of IRS Notice 2009-68, disagreements still abound regarding whether this strategy is possible. The two most commonly cited counterpoints are a letter from the American Benefits Council, published in response to IRS Notice 2009-68 and objecting to certain parts of it, and a discussion by noted IRA commentator Kaye Thomas about isolating basis from a 401(k) to complete a Roth conversion.
The letter from the American Benefits Council is essentially a position statement from the organization to the IRS, regarding the rollover rules under IRC Section 402(c)(2), suggesting that the organization believes the IRS' interpretation of IRC Section 402(c)(2) is incorrect, on the grounds that it is not an effective means of tax and retirement policy, that the guidance itself is incomplete and can lead to unusually problematic rollover situations, and that it is not consistent with the historical evolution of IRA rollover rules. In addition, the organization simply questions the IRS' interpretation outright as being different than their own reading and interpretation of IRC Section 402(c)(2). Notably, though, while the American Benefits Council may disagree with the IRS, the reality is that the IRS has not changed its position at this time.
On the other hand, the article by Kaye Thomas suggests, in essence, that the IRS' guidance itself is still ambiguous about a particular form of the rollover strategy, and advocates that it could be interpreted favorably on behalf of the taxpayer (or at the least, doesn't appear to be in direct contravention to the IRS' position in IRS Notice 2009-68). Thomas suggests a strategy which has actually been advocated by many IRA experts for a long time (and was previously discussed in the June 2009 issue of The Kitces Report as well), which is a multi-step process to completing a rollover. This "conservative" approach suggested that as a first step, the retirement plan would make an outright distribution to the participant. Once the plan has been fully liquidated in a distribution to the participant, he/she rolls over an amount equal to the pre-tax value to an IRA, and then subsequently and "separately" rolls over the remainder of the distribution to a Roth IRA. The amounts that should be allocated to pre-tax money were rolled over first to ensure the proper application of the ordering rules under IRC Section 402(c)(2). The remainder, which would theoretically only be after-tax funds at that point, simply needed to be rolled over to a Roth IRA (completing the conversion) before the normal 60-day deadline that applies to rollovers. The most significant caveat to this approach was simply that if the plan participant receives a full outright distribution, the mandatory 20% withholding rules will apply. Thus, to follow this approach, the client would be need to make up the missing 20% of the distribution out of pocket to complete the pre-tax rollover, then roll over (as a conversion) the remaining after-tax funds to the Roth IRA, and finally recover the 20% "excess" withholding when the tax return is filed early in the subsequent year. Depending on the size of the 401(k) account and the client's available liquidity, having funds available for the 20% withholding might have been problematic, but otherwise the strategy was presumed to be sound.
Strictly speaking, the IRS' guidance under IRS Notice 2009-68 is still not definitively clear on the tax consequences of the final step - the rollover of the remaining presumed-to-be-after-tax funds to the Roth IRA as a conversion. It is clear, under the IRS' guidance itself, that when a distribution occurs and only part of the amount is rolled over, that the rollover will be pre-tax funds under IRC Section 402(c)(2) and that the remainder in the client's account will be the after-tax funds. However, this assumes that the remaining (after-tax) amounts stay in the client's taxable account. In Thomas' opinion, this should also mean that a subsequent rollover of the remaining funds must be after-tax only, since the IRS already said (indirectly) that the preceding rollover was all the pre-tax funds; in other words, "what else is left" at that point to convert but an after-tax remainder?
So what is wrong with this approach? The criticism of the Thomas approach (and in light of the IRS' overall scrutiny of such transactions) is the idea that doing a rollover of the pre-tax funds and a subsequent rollover of the after-tax funds may still, in the end, be treated as a single rollover. After all, there was only one distribution, and the rules of 402(c)(2) are ultimately meant to describe the tax consequences of a single distribution, not of a multiple rollover transaction. In other words, perhaps the fact that both rollovers occurred within the 60-day period and pertained to a single distribution means, in the end, they're equivalent to a single rollover, especially if the IRS chooses to apply the step transaction doctrine to treat them as a single taxable event. Unfortunately, though, if the transaction is treated as a single rollover, then the end result is that once again cost basis must be allocated pro-rata amongst all of the destinations of the single rollover; the attempt to split funds would be foiled once again.
The Reality
In the end, there is still truly no guidance to definitively support the various approaches advocated to split pre-tax and after-tax dollars from a 401(k), with the goal of rolling over the pre-tax amounts and converting the after-tax amounts, although the weight of the evidence from the IRS suggests that they believe it should not be possible (not the least of which, because they issued IRS Notice 2009-68 in the first place to attempt to 'clarify' the issue, even though some gray areas remain).
Accordingly, the two articles described here - the letter from American Benefits Council and the article by Kaye Thomas - are inconclusive at best. In point of fact, the American Benefits Council letter simply articulates a series of points on which the organization disagrees with the IRS. It does not change the fact that the IRS has published guidance, and what that guidance itself says. The organization is simply pointing out that they believe the IRS' perspective is incorrect, and asks the IRS to change it to something that they believe is better reflective of good tax and retirement policy (and in their view, a 'more accurate and reasonable' interpretation of the tax code itself). The Thomas article, on the other hand, points out what is ultimately still a somewhat gray and ambiguous area about a particular form of the distribute-and-rollover strategy to utilize IRC Section 402(c)(2), but still is not ultimately definitive or "safe" to execute. At best, it provides the grounds by which a client could object to the IRS if challenged; it does not necessarily mean the client will be deemed correct by the IRS or the courts in the end. It is hard to even estimate a likelihood that the client would prevail; however, from a practical perspective, it seems likely that the IRS would at least try to challenge the position if discovered, as the Service is trying hard to cut down on perceived abuses and loopholes regarding Roth conversions. On the other hand, it may still be difficult for the IRS to discover taxpayers who utilize the strategy in the first place, so it is similarly true that while the risk of challenge is high, the risk of discovery to even be challenged in the first place is low (a similar plight applies to the so-called "Backdoor Roth IRA contribution").
To say the least, this means that clients who are interested in such a strategy should be cautioned that there is still significant ambiguity and some risk. In addition, it's notable that the mere fact a 401(k) provider is "willing" to issue two checks is not a basis for avoiding pro-rata treatment; the administrative implementation of a distribution is not legal guidance about the tax treatment! Although some practitioners have suggested that clients may as well "go for it" since they can always recharacterize the conversion later if the tax consequences are unfavorable, it is notable that this may not be an option if the IRS does not challenge until after the recharacterization deadline (i.e., the statute of limitations for the IRS to question the transaction lasts far longer than the time horizon a client can recharacterize a Roth conversion). In the end, some clients may indeed still wish to "go for it," but should at least be unaware that the path is highly uncertain at best, and at worst is directly contradicting the IRS' own position on the issue.
The more conservative approach would be to simply take the IRS' guidance at face value - given the "clarification" of IRS Notice 2009-68 - that it is not possible to split the pre-tax and after-tax funds from a 401(k) for the purposes of rolling the pre-tax amount to a traditional IRA and converting the after-tax remainder. Of course, this does not necessarily mean it is bad to complete a Roth conversion of a 401(k). In point of fact, the new rules allowing direct conversion of 401(k) plans to Roth IRAs are still appealing, as the direct conversion at least ensures that the client can use all of the after-tax funds within the 401(k) and is not required to aggregate other IRAs when calculating a pro-rata share of after-tax funds. But it is still a pro-rata distribution.
http://online.wsj.com/article/SB10001424052702304441404577480690440266320.html
I don't really think there is THAT much of a lack of clarity now.
The IRS explicitly issued guidance on this to emphasize their views, because people were getting creative with workarounds.
Now we have people getting creative with workarounds to the IRS's guidance trying to close the perceived loopholes in the first place.
The fact that the IRS is playing whack-a-mole trying to write guidance to prevent people from abusing makes it pretty clear what their views and intentions are!
- Michael
At this point all that would be left is the rollover ria that contains only the after tax funds. Since the value of those funds are equal to the basis the conversion to the Roth should not have any tax consequences.
This obviously only works if you are willing to roll ALL of your pre-tax iras into the plan to avoid the pro-rata rule.
Thoughts?
If you have a bona fide 401(k) plan that only allows pre-tax rollovers into the plan, this would work to "siphon" the pre-tax funds off, leaving an after-tax remainder.
The caveat is that you have to be ready to roll ALL the pre-tax IRAs to siphon accordingly. And there's still no reason or need to keep the old pre- and post-tax funds in separate IRAs. They're all aggregated for tax purposes anyway. You may as well hold the pre- and post-tax amounts in one account for tax purposes when you extract them from the old 401(k).
- Michael
I have never been fully sure if this new guidance disallows this now (I have scene many IRA experts question the same thing). Do you have any thoughts on just distributing the after-tax money and rolling over the pre-tax money only to the IRA? Thanks!
Alas, I don't think the strategy is any more feasible now. But I do see more and more inquiries into it as more baby boomers retire!
- Michael
See Life & Death Planning by Natalie Choate for more details on this strategy and also note that IRS Notices do not have the force of law and the dumb Notices are often rejected by the Tax Court!
I understand the IRS position on 2009-68. However, if an employer is doing separate accounting of the balances (which they may not be required to do), pre-tax and after-tax money types, then the distribution of the after-tax protion should be calculated using the principal after-tax contribution as the numerator and only the total after-tax account balance as the denumerator. I refer to IRC 72(d)(2) as stating that the two in effect are separate contracts.
If there has not been separate accounting then the denumerator would be the total account balance (pre-tax + after-tax).
Cheers, Reed
Let me be more specific ...
In my case, at age 71, my employer distributed the full amount of my 401K as required by the plan. There were 3 components: IRA, Roth, and After Tax.
Let's say $100K was in my account: $40K IRA, $40K Roth and $20K After Tax. I rolled over the full amounts of the IRA and Roth separately. I received the separate check for the $20K After Tax and I plan to roll that into a separate Roth.
Wouldn't the worst case be that the IRS would tax withdrawals (ehen I take them) as a traditional IRA? Or is there a worse penalty???
The worst case scenario is that the IRS would look at your $60k distribution from the traditional 401(k) - $40k pre-tax, $20k after-tax - and declare that because 2/3rds of your traditional 401(k) was taxable, 2/3rds of your $20k Roth rollover should have been taxable. This means you'd owe the income taxes on $13,333, plus any late penalties that would apply for failing to pay these taxes at the time of conversion (which may be fairly modest given low interest rates). In the extreme, additional penalties can apply if the IRS believes there was fraudulent intent and/or this results in a substantial misstatement of income.
Notably, your $40k already in a Roth 401(k) can roll over to a Roth IRA without a problem. This is just about the $60k from the traditional 401(k) side that includes a mixture of pre-tax and after-tax contributions.
- Michael
Would the IRS approve?
The issue is not whether you can DO the rollover, but the tax treatment.
Can you roll $20,000 to a Roth and $80,000 to a traditional IRA, yes.
Can you claim all $20,000 that went to the Roth is after-tax funds? No. You rolled over all the money, and when everything is rolled over, the pro-rata rule applies. It will be $4,000 basis and $16,000 gains on that $20,000 Roth conversion.
That's the point of the article here. You CAN rollover and partially convert. You cannot cherry-pick after-tax funds for the tax treatment of the rollover and partial conversion.
- Michael
We are not CPAs but if those 1099Rs are prepared as above, would a CPA treat them as anything else? Time will tell.
The problem is that the 1099-Rs are being crafted on the assumption that the pre-tax portion is rolled over and the after-tax portion is being taken as an outright distribution. In that case, the reporting is correct.
Rolling over the after-tax distribution (to a Roth IRA) changes the treatment previously reported on the 1099-R. Which means just reporting what was on the 1099-R is no safe harbor for avoiding consequences and penalties (although I'll grant it certainly reduces the likelihood of getting caught in the first place!).
- Michael
Additionally, the Federal government is doing the same. See: Additional Contributions Program of the Federal Civil Service Retirement System.
Joel
Some older plans explicitly have a standalone, separate plan that was collecting after-tax contributions, which makes this permissible (as there's no requirement to apply the pro-rata rule across multiple plans, just across multiple distributions from a single plan), but that's generally the exception, not the rule.
- Michael
- Michael
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Federal employees in CSRS have a phenomenal benefit called the CSRS Voluntary Contributions Program (CSRS VCP). This benefit allows CSRS (and CSRS Offset) to contribute 10% of the base pay they’ve received over the years into a special after-tax account.
Your contributions do earn a small amount of interest – and the interest is tax-deferred.
The VCP was designed to allow CSRS to contribute extra money into a special account that would buy an annuity to supplement your CSRS pension.
But once your money is in the VCP – you actually have two choices
Choice #1) Leave the money in the VCP account until retirement – when your money is traded in for a VCP annuity (which we’ll be discussing here)
Choice #2) Transfer the money out of your VCP account (most commonly to a Roth IRA)
We’ve talked a lot about the benefits of transferring your money to a Roth IRA. The biggest benefit being that the VCP becomes a way to max-fund a Roth IRA even for people who make ‘too much money’ to contribute to a Roth.
But let’s take a look at the other option – buying the CSRS VCP annuity.
Increasing Your Pension?
Sometimes pamphlets present the VCP as a way to ‘increase your CSRS pension’. BUT – you need to know that even if you bought the VCP annuity – it is separate from your CSRS pension and has different rules than your CSRS pension.
How Much Income Will You Receive?
If you want to buy the CSRS VCP annuity – the amount of monthly income you’ll receive is based on how much money you had in your VCP account – and what age you retire and start the annuity.
The more money you have in your VCP account at retirement, and the older you are when you retire – the more money you’ll receive each month from the VCP annuity.
At age 55, every $100 you have in your VCP account at retirement will provide $7/year. So for a quick example – if you retire at age 55 with $100,000 in your VCP account – you’ll receive $7,000 a year ($583/month).
At face value, many people look at the ‘payouts’ of the VCP annuity and it doesn’t look that bad. But the real problems with taking the VCP annuity are in the details of how it works.
Here are the biggest problems I have with the CSRS VCP annuity.
Problem #1) No COLA Increases – Ever.
There is no cost of living increase at all on the CSRS VCP annuity.
So continuing our example of $7,000 a year – you’ll be receiving $7,000 a year for as long as you live – it will never increase. That is a huge disadvantage.
So when the VCP annuity is billed as a way to ‘increase your CSRS pension’ – it’s not entirely accurate. While your regular CSRS Pension will likely be increased by COLA over the years; you need to know that your VCP annuity will not be increased by COLA – ever.
Problem #2) Survivor Options on VCP are Very Different (in a Bad Way)
There is an option for a survivor benefit on the VCP annuity – but it is very different from the survivor benefits of your CSRS pension.
If you want a survivor benefit on your VCP annuity – you must name them on your paperwork at retirement. Then – there is a 30 day window where you can make changes to your survivor on the VCP annuity.
But after that 30 day window - no matter what - you can not make changes.
And I mean – no matter what.
What if your survivor passes away before you? You can not even name a new survivor. But you will continue to have the cost of the survivor benefit taken out of your annuity each month.
Here’s the ‘Note’ at the bottom of Section 31A3.1-1 ‘Purchase of Additional Annuity’ in OPM’s CSRS/FERS Handbook:
“If the employee elects to provide additional survivor annuity, the reduction of the additional annuity rate is permanent. The reduction will not be eliminated if the designated survivor predeceases the retiree, nor can the additional survivor annuity be transferred to a different person”
This is incredibly restrictive.
Here’s a link to Chapter 31 on the VCP if you’d like to see for yourself…
Problem #3) Income Starts Right Way – No Deferral Growth
If you take the CSRS VCP annuity – your annuity begins at retirement. This means you don’t have the choice to defer taking income and let the money grow.
This ability to defer some retirement income is a very important factor in creating a retirement plan that will help you outpace inflation.
But with the CSRS VCP annuity, your income starts right away at retirement, and you don’t have that option.
The VCP Annuity Mixes After-Tax and Tax-Deferred Monies
When you take the VCP annuity, all of your VCP money is turned in to buy the VCP annuity. While your contributions to the VCP are after-tax, the interest you earn on your contributions is tax-deferred.
But when you transfer your VCP, you have the option to send your after-tax contributions and tax-deferred interest to different places.
This means you can keep the money separate.
So when you transfer your contributions to a Roth IRA – all of your money stays after-tax. And you can send your tax-deferred interest to another tax-deferred account like a Traditional IRA or even into the traditional portion of your TSP.
Keeping your money separate like this gives you better advantages for tax planning.
But when you do the VCP annuity, you have to turn in the entire balance of your VCP account – after-tax contributions and tax-deferred interest. That means that the money you receive as income from the VCP annuity is partially after-tax and partially tax-deferred.
For most people, the part that is taxable is much smaller than the after-tax portion. But this complication can make tax planning in retirement more difficult.
VCP Annuity Misses Out on the Real Power of the VCP
While it’s always worthwhile to understand your options – if you take the VCP annuity – you’re missing out on the real power of the VCP…
The real power of the VCP is that it allows you an alternative way to max-fund a Roth IRA.
Once your money is in a Roth IRA, you have a lot of choices in how you invest it. Depending on where your Roth IRA is held, you may have a wide range of investment options indeed.
The kicker for most people is that it is difficult to take advantage of a Roth IRA. The annual contribution limits are pretty small, and depending on your income, you may not be able to make annual contributions to a Roth IRA at all.
However something interesting happened in 2010, and the limits on who could convert money into a Roth IRA were removed. This means that you might make ‘too much money’ to contribute money directly to a Roth IRA, but that you could still be eligible to convert money from other qualified accounts into a Roth IRA.
So what’s the catch?
Well first, you have to pay taxes on the amount converted now.
But second, the money you convert into a Roth IRA can only come from other ‘qualified accounts’ (think Traditional IRA, TSP, 401(k), etc.). And most of those qualified accounts also have their own limits on how much money you can put in.
So even though you can convert money from those accounts into a Roth – you can only convert as much money as you already have in those accounts.
Now, enter the CSRS VCP. It is also considered a qualified account – but the contribution ‘limit’ is really very high (especially compared to other qualified accounts).
Everyone’s limit will be different – but it’s not uncommon for CSRS to have a VCP contribution ‘limit’ over $100,000.
And it has a unique benefit in that your ‘contribution limit’ is cumulative, and not annual. So for CSRS who have their financial ducks in a row approaching retirement, the VCP is a tremendous opportunity to get quite a bit of money into a Roth IRA. That’s the real power in the VCP.
Once your money is in a Roth IRA – you still have a wide range of investment choices. But when you make those investments in your Roth IRA, you can get the advantages of the Roth on those investments.
Important: VCP Annuity is the ‘Default’ Choice
But even though most people decide to transfer their VCP to a Roth IRA – it’s important to know that OPM still considers buying the VCP annuity as the ‘default’ choice.
So if you intend to transfer your money to a Roth IRA – but don’t file the proper forms by retirement, OPM will sign you up for the VCP annuity anyway because that is the default action.
Looking for More Info on CSRS Voluntary Contributions?
There’s lots more to know about the CSRS VCP program. Over the years I’ve gotten so many questions about the VCP that I’ve taken my experience helping clients with the VCP and compiled it into the most comprehensive book available on the topic: The Best Kept Secret in CSRS.
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About the Author
Micah Shilanski, CFP
Micah Shilanski is a CERTIFIED FINANCIAL PLANNER™ professional who specializes in helping federal employees get the most out of their retirement benefits. Micah is an independent fee-based financial planner, and only works with a select group of clients. Micah helps his clients with Federal Retirement planning, tax planning, retirement planning, estate planning and investment advice.
Yes, it is possible to do a conversion on the after-tax amounts in the CSRS VCP, as it really does function as a standalone second plan. It also qualifies for some grandfathering rules that effectively allow this to happen as well (as it actually predates all the ordering rules we're talking about here!).
We've actually had some clients do versions of this CSRS VCP strategy.
- Michael
Some older plans explicitly have a standalone, separate plan that was collecting after-tax contributions, which makes this permissible (as there's no requirement to apply the pro-rata rule across multiple plans, just across multiple distributions from a single plan), but that's generally the exception, not the rule.
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I am perplexed. According to you pro-rata calculations apply to 401(k) plans that have after-tax contributions but does not apply to plans that have an explicit stand-alone plan which has after-tax contributions.
Are you saying there is no pro-rata calculation requirement when two distributions are made from the "stand-alone" plan one for the contributions portion going to the Roth IRA and the earnings portion going to the Traditional IRA?
Is this not "multiple distributions" from a single plan notwithstanding the fact that it is not the employer's primary plan?
Look at it this way.
If I have Plan A, and I make pre-tax and after-tax contributions, it's pro-rata. One plan, one pool of money, pro-rata.
If I have Plan A, and I make pre-tax contributions to it, and entirely separate standalone Plan B which happened to get after-tax contributions, and the employer has two plan documents that each dictate the separate existence of the plan, then I can do whatever I want with each separate plan. The pro-rata rule applies to Plan A for Plan A (which has ONLY pre-tax), and the pro-rata rule applies to Plan B for Plan B (which has ONLY after-tax), so you can do the transaction you're trying here.
A 401(k) is one plan with two types of contributions. CSRS plus the separate CSRS VCP is an example of two plans.
- Michael
Additionally, the Federal Government's Voluntary Contributions Program (a sole after-tax voluntary savings plan) is honoring requests for Direct Rollover of the basis to a Roth IRA and Direct Rollover of the earnings portion to a Traditional IRA.
Joel
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Taxable distributions rolled over from an employer plan to a Traditional IRA are not labeled a "conversion" but a "rollover" Why? Because no tax is due.
After-tax contributions rolled over from an employer plan to a Roth IRA is, likewise, not a "conversion" but a "rollover". Why? no tax is due.
Just like a rollover of taxable distributions from employer plans provides for much larger Traditional IRA balances than what would otherwise be generated by regular deductible contributions to the Traditional IRA the rollover of after-tax balances from employer plans to Roth IRAs provides for much larger Roth IRA balances than would otherwise be generated by regular after-tax contributions to a Roth IRA.
The term "conversion" should be used only when one is changing the tax status of the account from
A conversion IS a rollover, literally by definition of the tax code. A "conversion" is simply the technical name for "a rollover that starts in a traditional account and finishes in a Roth account". Which is the whole reason why you can convert after-tax amounts in the first place. A "conversion" is not defined by whether the rollover amount is taxable; it's defined as a rollover that goes from a traditional IRA/401(k) to a Roth account, and tax consequences simply do or do not occur as a separate consequence (based on whether the amount was pre-tax or after-tax when leaving the original plan).
None of that changes the proper tax reporting of a rollover distribution from an employer retirement plan that has pre-tax and after-tax amounts, which remains "pro-rata" per all the citations discussed here, and therefore cannot be split. Congressional intent is clear on this, and the IRS' updated guidance reinforced their interpretation of Congressional intent, which is for pro-rata treatment to apply.
It's unfortunate perhaps, but you cannot redefine terms that are already codified in the Internal Revenue Code to achieve a different result.
- Michael
That's correct. Once there are any after-tax contributions in a traditional IRA - whether by original contribution, or rollover of after-tax amounts - you're "stuck" doing pro-rata calculations on distributions indefinitely going forward, as you can never extinguish the after-tax amounts entirely until the account itself is extinguished entirely.
This is all tracked and reported on an annual basis on Form 8606.
- Michael
In reply to your response to me above, I presume I would be stuck doing the same pro-rata calculations if I annually converted funds from the rollover IRA to the Roth IRA.
Correct?
Would I eliminate this new problem if my conversions of rollover IRA fund to Roth IRA funds took place in a totally separate set of IRA/Roth accounts with another plan sponsor?
In response to your reply to my question above, I presume I would still be stuck doing pro-rata calculations if I annually converted some of the rollover IRA funds to a Roth IRA. Correct?
Would I avoid this if I performed the conversion from a rollover IRA ro a Roth IRA in a completely separate set of accounts with another plan sponsor?
That's fine if you KEEP the after-tax contributions in cash in a bank/brokerage account.
But if the after-tax amounts are subsequently rolled into a Roth account as a conversion, then ultimately you still rolled over everything and the pro-rata rule applies. The fact that the money took a brief stop in a bank account on the way to being rolled over doesn't change the fact that everything was rolled over, which triggers the pro-rata rule.
- Michael
I agree with your analysis. Reviewing the IRS Spring 2010 Volume 10 Employee Plan News page 4 you are correct. Te IRS clearly indicates the pro rata rules apply.