Executive Summary
Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis, of course!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at two questions related to the increasingly popular strategy of making after-tax contributions to a 401(k) plan and subsequently converting them to a Roth, either via an intra-plan conversion to a Roth 401(k), or using ongoing in-service distributions from the 401(k) to convert to a Roth IRA!
Intra-Plan 401(k) Conversions To A Roth 401(k) ("Designated Roth Account")
Question/Comment: Our company just added in-plan Roth 401k conversions to our plan, as well as allowing after-tax contributions to the Traditional 401k. Question is - do you think the pro rata rule applies when you do an in-plan Roth conversion, or can you isolate the after-tax money in the Traditional 401(k) when converting to the Roth 401k? All the writing we've found only addresses the IRS ruling last fall re: moving after-tax money to a Roth IRA. My gut tells me the pro rata rule applies to in-plan conversions to a Roth 401k, but I can find that anywhere. Any thoughts?
The Small Business Jobs Act of 2010 created IRC Section 402A(c)(4), which stipulated that a distribution from a 401(k) plan can be rolled over to a designated Roth account (i.e., a “Roth 401(k)” plan), in what now is often called an “intra-plan Roth conversion” transaction.
As a Roth conversion, the funds that are transferred from the 401(k) to the Roth 401(k) are not subject to any early withdrawal penalties. However, IRC Section 402A(c)(4)(A)(i) is explicit in stating that the conversion is still a distribution that is taxable, to the extent it otherwise would be.
And because it’s still treated as a “distribution”, indeed that means the guidance of IRS Notice 2014-54 about distributions that include after-tax contributions out of a 401(k) plan still applies, so the distribution is subject to the pro-rata rule here.
In other words, this may be an intra-plan conversion to a Roth 401(k) and not to a Roth IRA, but it’s still a distribution being converted, so the same pro-rata tax treatment applies to the money that is leaving the original traditional 401(k) account. In fact, the guidance under IRS Notice 2010-84 explicitly states in Q&A-7 that “the taxable amount of an in-plan Roth rollover is the amount that would be includible in a participant’s gross income if the rollover were made to a Roth IRA.” Which means, again, that the pro-rata rule will apply here to an intra-plan Roth conversion, too.
Notably, though, the IRA aggregation rule will not apply to an intra-plan Roth conversion, as the aggregation rule specifically is only for IRAs; in the case of employer retirement plans, you’ll calculate that pro-rata distribution amount based only on the retirement plan account balance (and after-tax contributions) for that employer. If the client does multiple intra-plan conversions over time (as new contributions are made), each conversion will be still subject to the pro-rata rule, based on the total value and total after-tax contributions of that plan at that time.
Notably, under the expanded intra-plan Roth conversion rules from the Small Business Jobs Act and IRS Notice 2010-84, the same outcomes would apply for an intra-plan 403(b) or 457(b) conversion as well. On the other hand, it’s important to remember that an intra-plan Roth conversion is only permitted if the employer retirement plan offers a designated Roth account and specifically allows conversions – though fortunately, it sounds like your plan has already taken that step!
Ongoing Roth Conversions Of In-Service Distributions From A 401(k) Plan To A Roth IRA
Question/Comment: How do the Roth conversion rules work for in-service distributions of after-tax 401(k) contributions? Our company allows for in-service distributions, but only of after-tax contributions... could I theoretically max out my 401(k) pretax, and then make say $30-$40k in after-tax contributions, and then do an in-service of just the after-tax to a Roth IRA?
The new rules of IRS Notice 2014-54 issued last fall regarding the Roth conversion treatment of 401(k) plans that include after-tax contributions apply to any distribution from a 401(k) plan, whether it is an in-service distribution or one that occurs after retirement/separation from service.
So the good news is that yes, it absolutely is possible to do the favorable after-tax-to-Roth splitting treatment for in-service 401(k) distributions under that guidance – presuming, of course, that the plan allows in-service distributions in the first place (which it doesn’t necessarily have to do).
However, the “bad” news is that the plan does need to comply with the guidance in IRS Notice 2014-54, which means it still is not possible to distribute only the after-tax contributions for Roth conversion. Per the IRS’ latest guidance, any/all distributions must be done on a pro-rata basis as the funds leave the plan if a Roth conversion is occurring, which means if you try to take just some of the account balance, you only get some of the after-tax contributions!
Example 1. A 401(k) plan includes $50,000 of after-tax contributions and a total balance of $250,000. If the plan participant takes a $50,000 in-service distribution, under IRS Notice 2014-54, a distribution from a plan that was 20% after-tax ($50k out of $250k) means the distribution will be treated as 20% after-tax, so the $50,000 will be $10,000 of after-tax and $40,000 of pre-tax. Once that distribution occurs, you can send the $10,000 of after-tax to a Roth (as a tax-free conversion of basis) and the $40,000 to a traditional rollover IRA.
Notably in the above example, trying to take just the after-tax funds means you only get $10,000 of the after-tax out. If you want all $50,000 of after-tax (100%) out of the plan, you have to take all (100%) of the plan’s account balance in the first place (which may or may not even be possible as an in-service distribution, depending on the details of the plan and its flexibility for in-service distributions). Notably, there is an old rule under IRC Section 402(c)(2) that allows just the after-tax to be taken out first, but that applies only if the funds are not rolled over or converted (i.e., they land in your checking/investment account, not in an IRA or Roth RIA); if you roll over or convert, the pro-rata rule of IRS Notice 2014-54 applies.
Now, one partial exception to this rule is that if the plan separately accounts for the after-tax contributions and associated growth, it is possible to distribute and roll over just the after-tax and its associated growth but not the rest of the plan. In this case, the pro-rata rule would only apply to the separate accounting share.
Example 2. Continuing the prior example, assume that the $50,000 of after-tax contributions also has $40,000 of (pre-tax) growth associated with it (for a total value of $90,000), which are separately accounted for from the remaining $160,000 in the 401(k) (which includes $80,000 of pre-tax contributions and $80,000 of pre-tax growth). In this situation, if the plan participant takes $50,000 from the after-tax share, it still won’t be a pure $50,000 of after-tax, but it will be treated as being 55.6% after-tax ($50,000 out of $90,000), which means $27,778 will be after-tax and only $22,222 will be taxable in the Roth conversion (or alternatively, the $27,778 can be sent to the Roth on a tax-free basis and the $22,222 can be rolled over to a traditional IRA to avoid any tax consequences, but it still means not all the after-tax came out of the plan at once).
In the above example, separate accounting still requires the pro-rata rule to apply, but only to the after-tax and its associated growth. So the $50,000 distribution is now $27,778 after-tax, instead of only $10,000 after-tax in the prior example. And the plan participant could get all of the $50,000 of after-tax out by withdrawing “just” the $90,000 in the after-tax account (including contributions plus growth) while leaving the remaining $160,000 behind.
Notably, if a plan separately accounts, this also means that on an annual/ongoing basis, you could contribute to the after-tax portion of the account every year, and then do a Roth conversion out every year. To the extent that the money is the account for only part of the year, there will likely be little-to-no growth in the account, so it would at least be almost entirely just an after-tax conversion each year. It would basically be a kind of “supercharged” backdoor Roth contribution, though as with other backdoor Roth contributions, it’s probably still a good idea to let the contribution ‘season’ in the account for a while, rather than trying to contribute and immediately convert. If the plan does not separately account, you could still do this strategy, but you will be subject to the pro-rata rule based on the entire account when each conversion distribution occurs (which may be fine if the plan allows you to withdraw the whole account as an in-service distribution, but if not you’ll be stuck just ‘dribbling’ out the conversions of after-tax over a period of time, with the remainder converted all at once when you separate from service).
I hope that helps a little!
Michael – The IRS Ruling has often been understood as a way to access pre-tax money in a 401k, but it seems that’s oversimplifying it. What the ruling really allows is for 401k participants to decide how to allocate a distribution between receiving accounts – it doesn’t actually change the nature of the distribution itself (from a pro rata distribution to an all-post-tax distribution). For complete distributions, it’s not an issue, but for partials that an important distinction.
So what’s to prevent a participant from requesting a distribution from the Trad 401k that has pre- and post-tax money in it, converting the post-tax portion to the Roth 401k, and then rolling the pre-tax back into the Trad 401k? The distribution was still pro rata, and the employee chose how to allocate the funds. Does the fact that they chose to allocate some of that right back to the original plan create a problem? Maybe since this is a distribution from the Trad 401k, it can’t be rolled back to the source. It doesn’t seem like this would work, but maybe?
Great article. I have a situation as an Advisor where a local large company, upon rollover of the 401k will cut a check to the Clients IRA but will not make the after tax portion out to their Roth IRA. That check is made out to the client only. Can we still direct those funds to a Roth? The client would have to either sign over that check or deposit and write out a check if that is acceptable. But then, how would we file that for 2015? Your thoughts.
Ron,
You can simply cash the check for the after-tax and then write a new check to the Roth IRA within 60 days. That’s a ‘normal’ rollover (however ALL of these were done, before trustee-to-trustee transfers were made common).
With pre-tax funds this approach is problematic because the employer will normally withhold 20% for taxes. However as an after-tax-only distribution, there SHOULD be no taxes withheld, so simply do a normal rollover here. 60-day clock is ticking though!
– Michael
Thanks for this clarifying article about in-service after-tax withdrawals. It is very helpful, as usual.
Hi Michael, thank you for the great information you provide. Can you clarify what constitutes “separate accounting” in a 401(k)? My (Fidelity administered) 401(k) shows a contribution summary that splits out pre-tax, after-tax, and company match. The investment section does not separately present pre-tax/after-tax. Does this constitue separate accounting? Thank you.
The plan will always record keep the sources of money separately. They key to check into this strategy is seeing if your company allows an “after tax withdraw”. Check your SPD or even easier call your provider and ask “does my plan have an after tax w/d and what sources of money will it pull from”. if they have that w/d it will more than likely just pull from your after tax contributions. If you have made contributions in the past of course you will have to worry about the earnings and paying taxes. But if not and you plan on doing the strategy ongoing also ask how often you can take the w/d. Doing it more often will of course help avoid taxes on the gains
2014-54 guidance had nothing to do with in service conversion. It had only to do with logistics of splitting the portions when the full balance is available (typically separation from service).
The key issue now and before that ruling was that a distribution is treated pro rata based *on what is available to be taken out*.
Example 1: Joe Blow is 50 and is only allowed to take in service distribution of after tax money. Since the plan restricts the distributions to only after-tax than anything he sends to a Roth will be after tax basis + earnings.
Example 2: Joe Blow is 65 and his plan document allows him to take an in service distribution of all of his money. He no longer can just take the after tax portion. In order to get the full after tax out he needs to *also* rollover the entire pre-tax portion to an IRA at the same time.
Example 3: Joe Blow is is 50 and he previously rolled over a previous IRA/401k/etc. to his current employers plan. His plan document allows him to take an in-service distribution of both after tax and “rollover” money (previously rolled in sums). Joe can’t just take the after tax portion. Technically speaking (if you read the pertinent code/guidance/etc.) pro rata rule dictates that he take the after tax and the previously rolled over pre-tax 401k/IRA funds.
^^I believe a lot of people/companies are screwing up #3 (and some are screwing up 2), but I doubt the IRS is actually going to enforce that any time soon (they may even not fully understand that their rules point to an issue with #3).
Interesting. In my case, I am 48 and have:
– A large Rollover IRA
– A small non-deductible Traditional IRA
– An employer 401(k) that allows after-tax contributions and in-plan Roth conversions
It seems that I have two “backdoors” available to me, and I have to choose one or the other. Either:
1. Roll my Rollover IRA into my 401(k) and take advantage of the regular ol’ backdoor Roth (by converting my small nondeductible Traditional IRA to Roth), BUT forgo the ability to do an in-plan Roth conversion of after-tax contributions, since I would fall into example #3 above. OR
2. Leave my Rollover IRA as-is, forgo the ability to do regular ol’ backdoor Roth conversions due to the pro-rata rules, BUT have the ability to do in-plan Roth conversions of after-tax contributions.
Am I thinking about that correctly? If what is described in the comment above is accurate, I nearly (and unknowingly) eliminated my ability to do (much larger) in-plan conversions in favor of small ($5,500) backdoor Roth conversions. This is tricky stuff…
The key is to check with the plan provider and see if the after tax w/d is separated out by itself. Your plan may have 2 in service withdraws. “Rollover w/d” (of the Ira rollin source of money) and after tax w/d (of the separated after tax contribution source). If they do that #3 won’t matter and even if it does apply and the after tax source is still seperately accounted for there will probably be a source heirarchy and pull from the after tax money first on the in service distribution. Leaving the Rollin money alone
Thanks for another great thought provoking article Michael. A couple of questions:
1) If I make a non-Roth after-tax contribution to my Solo 401-K, can I then immediately make an intra-plan Roth conversion of those funds? (Assume my plan allows it)
2) What is the lowest salary I can pay myself (S-corp) and still make the maximum 53K annual 401(k) contribution for 2015? Can I pay myself 53K in salary, make an 18K employee contribution, 13.25K employer contribution (53*.25 = 13.25) and the rest (21.75k) in an employee non-Roth after tax contribution?
Thanks for the information, Michael. Is it possible to provide some links to the separate accounting rule as explained in example 2, preferably something from the IRS itself? That is precisely my situation, and I’d like to read more about it. Thank you very much.
Hi I have a solo roth 401k & 401k….separate accounting in my self-employed pension plan. I also have a self directed roth IRA with a custodian. Would it be possible to roll-over or do a direct transfer from the self-directed with the custodian to my solo roth 401k? I’d like to avoid the annual fees. Thanks for your help.
Michael,
Thank you for this information – its very hard to come by even when asking several CPAs.
My company’s 401k allows in-service withdrawals and after-tax contributions (which are separately accounted for). I’m thinking of contributing up to the 53k limit each year and immediately rolling the after-tax portion to a roth IRA. You say in your article it’s better to let the money “season” for a while – why is that? I’d rather this account have no growth to avoid taxes upon 100% conversion of this sub-account- no? In addition, my company match is part of our bonus in december so the pre-tax contribution will be anywhere from 18.5k (if I get no bonus and all the contributions were mine) to 37k (if the bonus is maxed). Therefore I cannot know how much after tax money will be allowable to hit the 53k max until the end of the year.
My company also allows an in-plan roth 401k conversion but from reading your other articles it would seem more advantagous to roll out of the plan into a roth IRA using the aftertax sub account each year. Is this correct?
Hey Michael,
Great info. Let’s see if you can solve an argument for me.
Let’s say someone has after tax money in their 401k and it is separately accounted for. And then they convert that into a newly created Roth IRA (they have never created or made contributions into a Roth IRA in the past). Would they be able to access the after tax contribution portion (not earnings) of that money without penalty before the 5 year aging??
Thanks!
Why would one want to “season” the in service after tax withdrawal to Roth IRA conversion but not for the intra plan, after tax to Roth 401k conversion? I know that some companies even allow for a nearly immediate automated after tax to Roth 401k intra plan conversion.
Great article! What if you have multiple 401(k)s from previous employers and do an intra-plan conversion to a roth 401(k) with current employer? Does the pro-rata rule apply to all 401(k)s?