Executive Summary
As more and more baby boomers retire, an increasingly popular strategy is to split pre- and after-tax funds in a 401(k) at retirement, with the goal of rolling over the pre-tax funds into an IRA, and converting the after-tax funds into a Roth IRA, taking advantage of the non-taxable nature of the after-tax contributions.
Yet the effectiveness of the strategy is ambiguous at best; recent guidance from IRS Notice 2009-68 would suggest that the approach shouldn't be allowed at all, and although some esoteric and technical workarounds have been suggested, none have truly been tested or subjected to IRS scrutiny. As a result, while many 401(k) plans are willing to issue separate checks to accommodate those who wish to try the strategy, and the odds of getting caught are low, caution is still merited about whether the client will really end out with the desired tax treatment.
(Editor's Note: The details of this article were overwritten by IRS Notice 2014-54, updating the rules on Roth conversions of after-tax 401(k) distributions.)
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of after-tax contributions to a Roth IRA as a tax-free Roth conversion (since after-tax funds are not taxable when withdrawn or converted), and the remaining $80,000 to a rollover IRA.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.
In addition, under the Pension Protection Act of 2006, IRC Section 408A(c)(3)(B) was modified to provide that individuals can complete a Roth conversion directly from a 401(k) plan to a Roth IRA, without being required to first roll over the money to a traditional IRA for subsequent conversion (which would also cause the funds to become subject to the IRC Section 408(d) IRA aggregation rule, along with all other IRAs, when calculating the tax consequences of the conversion).
In the case of a rollover (including one that is converted to a Roth IRA), though, a slightly different set of ordering rules apply than the standard pro-rata rule, under IRC Section 402(c). Previously, most experts interpreted the somewhat complex provisions of 402(c) to indicate that when a rollover distribution from a 401(k) occurs, it is treated as coming first from the pre-tax portions of the account, and once all pre-tax amounts have been rolled over, any remaining rollovers are attributable to after-tax funds.
However, recent guidance from IRS Notice 2009-68 suggests a different treatment. Under IRS Notice 2009-68, Sherry must treat her IRA rollover as receiving a pro-rata share of the after-tax portion of the funds, and the Roth IRA conversion would in turn also receive a pro-rata share. Accordingly, if Sherry sent $80,000 to the rollover IRA and $20,000 to the Roth IRA, then the rollover IRA would include $16,000 of the basis (80% of the basis, since it was 80% of the rollover), and the Roth IRA would only be allocated $4,000 - which means in turn that the $20,000 sent to the Roth IRA will be taxable as a Roth conversion for the last $16,000.
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.
So what do you think? Have you tried the 401(k) splitting strategy? Would you counsel a client to do so? Are the benefits in the end really worth the risk?
The new interest in IRAs and tax compliance by the IRS may shed more light on this aspect of Roth conversions. Clarity would be so welcome!
http://online.wsj.com/article/SB10001424052702304441404577480690440266320.html
A strategy that I think can work in the right situation is to do a 401k distribution in two parts, pre and post tax, and place them in separate iras. Then if the client has a new 401k plan that allows rollovers you then rollover only the pre-tax Ira (many plans don’t allow after tax funds to be rolled in anyway) into the current 401k plan.
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?
Jason,
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
We have never tried to do the strategy of converting the after-tax amounts to a Roth IRA, but we do have clients who like to take the after-tax money as a separate check and just keep it in a brokerage account or use it to pay down debt. That way, they don’t have to worry about the pro-rata rule for each IRA distribution the rest of their life.
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!
We researched this issue at length to try to make it work for a client retiring two years ago. She was very interested in converting the after-tax funds to a ROTH. In the end, we (including her CPA/Tax Advisor) felt the only option was to take the conservative approach and give up on the ROTH. I was hoping your post was perhaps new information that this strategy was more feasible.
Cathie,
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
Once the cream is in the coffee, you can’t pour the cream back out. All you can pour out is creamed coffee.
Jason has this issue solved, great job Jason! Roll the entire distribution to an IRA; setup a Solo 401k to receive the pre-tax $’s from the IRA and then roll the post-tax $’s to the Roth IRA. You would have to rollover all pre-tax $’s in all IRC 408 IRA accounts. Note that some states treat these accounts differently for creditor protection and this may cause issues for some self-directed IRAs so check with your attorney if these issues apply.
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 recently retired. My 401k consists of 7% after-tax contirbutions, another 7% of earnings on the after-tax contributions and 86% pre-tax ocntributions and the earnings thereon. If I roll the 7% after-tax contribution into a roth IRA and the remaining 93% into a rollover and/or traditional IRA, what are the income tax consequences? Alternatively, if I rolled/converted a portion of the 401k into a Roth IRA each year, I presume 93% of each annual distribution would be taxable. Correct?
Michael,
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
What is the worst that can happen if you convert the 401K After Tax distribution to a Roth? My employer sent a separate check for the After Tax funds which I will roll into a separate Roth.
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???
Bob,
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
Assume an AFTER-TAX 401(K) PLAN subject to section 415 limits. Retiree takes a lump-sum settlement of $100,000. $20,000 is cost basis and 80,000 is earnings. $20,000 is directly rolled over to a Roth IRA and $80,000 is directly rolled over to a Traditional IRA.
Would the IRS approve?
Joel,
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
Michael, It seems to me that how the participant ultimately deals with the tax treatment will be driven by the 1099Rs received in the following year. It seems that a couple of large firms we have seen are doing your example and have indicated to us that the participant will receive two 1099Rs, one for a qualified rollover of the entire taxable portion and one as a qualified Roth rollover for the entire pre-tax amount. Neither which should show a taxable distribution.
We are not CPAs but if those 1099Rs are prepared as above, would a CPA treat them as anything else? Time will tell.
Public-sector plans are effectuating two Direct Rollover distributions—the basis portion going to a Roth IRA and the earnings portion going to a Traditional IRA. See: Calif State Teachers’ Retirement System, Virginia, North Carolina, Mass, Kentucky, Kansas.
Additionally, the Federal government is doing the same. See: Additional Contributions Program of the Federal Civil Service Retirement System.
Joel
There are a number of Public Employees Retirement Systems that specifically allow one to Directly Rollover the after-tax amount to a Roth IRA and the taxable amount to a Traditional IRA. These are: Kansas, Kentucky, Mass., North Carolina, Virginia and California State Teachers Retirement System.
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
In addition, under the Pension Protection Act of 2006, IRC Section 408A(c)(3)(B) was modified to provide that individuals can complete a Roth conversion directly from a 401(k) plan to a Roth IRA, without being required to first roll over the money to a traditional IRA for subsequent conversion (which would also cause the funds to become subject to the IRC Section 408(d) IRA aggregation rule, along with all other IRAs, when calculating the tax consequences of the conversion).
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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
Joel,
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
Since the rollover of the after-tax 401k contributions to a Roth IRA are taxed on a pro-rata basis of the total pre and after-tax balances in the 401k plan, how is the pre-tax 401k amount that is rolled over into a traditional IRA ultimately taxed upon distribution? Must one do a calculation on distributions from the tradition IRA over the rest of ones life?
What if you just took the after-tax contributions out as cash, and rolled the after-tax earnings with the pre-tax rollover?
Lauren,
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
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.
Michael, so what happens if the client rolls over the pre-tax $$ to a traditional IRA and just takes a cash distribution of the after-tax $$ (and keeps it in cash and doesn’t rollover to Roth IRA)? Is the amount of the rollover and the cash distribution still pro-rated and the client will owe tax on part of the cash distribution? Or is this scenario able to be split exactly between pre-tax and after tax $$ since there is no attempt at rolling to a Roth IRA? What’s the difference if there is any?
Doug,
If the pre-tax $$ are rolled over to a traditional IRA and the after-tax is taken as cash, the split is fine. The whole point of the rules is basically: if you take the after-tax as cash, you get just the after-tax. If you ROLL OVER the after-tax (and a Roth conversion is technically a rollover), THEN the pro-rata rules apply.
Or viewed another way, the standard rule is pro-rata in all cases, EXCEPT if you take the after-tax as cash and keep it, you can get just the after-tax funds. This was a leniency rule from Congress to specifically allow people to extract out their after-tax funds into their bank account if they want.
– Michael
Thank you, Michael. This article and your repsonse was very helpful!
Michael, What are the options given that I rolled-over my entire 401K (pre and post tax amounts) several years ago and now would like to transfer the post-tax amount to a Roth? Thanks.
Michael…assuming I’m retiring in 3 years and have been contributing to an after-tax account for 30+ years. And my company tells me an in-service distribution is only available for the funds I’ve contributed to this qualified plan. They will not allow me to move the company’s matched amount or any earnings..just the money I myself have contributed after-tax. Would this mean I could move the funds into a Roth without any penalty or taxes…and when I retire I can move the rest into a Traditional IRA? Or do I have to just move the 156k into a Traditional IRA (without having to pay taxes on any of it) to get the money out of the company 401k?
If I am required to move these to a Traditional IRA first and then I convert this to a Roth, would I still be liable for any taxes on gains from funds that are still in my company 401k? Thanks!
I have been contributing the max on both a pre-tax and after tax basis to my 401k for many years. This enables me to receive my company match and is a forced savings plan. For the after tax portion I know the earnings will be taxed at ordinary tax rates, likely higher than if I had contributed, instead over the years to a taxable account, where earnings would have been taxed at long- term capital gains rates. How can I minimize the tax impact when it comes time to roll over and tap into these funds, which are now considerable? I realize now the error of my ways. How can I dig out?
Michael –
Any new guidelines/recommendations on the 401(k) splitting strategy? I’m currently working with a client that has an old 401(k) worth $634,000. The account value includes after-tax contributions of $183,000. Not sure yet if the custodian with issue separate checks for the after-tax contributions and the remaining balance. If you have any current information on whether to carve out the after-tax amount and transfer to a Roth IRA with the remaining balance going to a traditional IRA, please let me know.
I think this discussion might depend largely on how your 401k plan is administered. In the case of most Fidelity plans… my understanding (which could be incorrect) is that Fidelity reports all taxable and non-taxable amounts distributed from a 401k on a 1099-R. If Fidelty reports a $0 taxable amount on the 1099R- then you are probably ok – unless the IRS requests Fidelity to redo the 1099-R at a later date. If this happens – my question would be if penalties are still applied – since you could state to your defense that you only reported (on your 1040) what Fidelity has provided to you on the 1099-R.
Actually what i said above is probably incorrect – please ignore it. (Especially ignore it, if you intend to do a 60 day roll-over and get separate checks ). However, a direct rollover might be treated differently depending on how the 401k is administered. (again – I am not an expert, and may be entirely incorrect – i wish the guidance was clearer)
does the pro rata apply to only the amount of the distirbution or to the entire 401 holding? my company tracks pre tax and post tax contirbutions, and each of their gains separately. they will distribute a reciept itemized check to my fund manager for only the post tax amount showing the taxable and non taxable amounts(gains and basis). if the pro rata only applied to the distribution, and i did it annually, my pro rata % would be small. (i have no funds there now, and the post tax contibutions occur late in the year) i’ don’t think i’d mind conservatively paying the prorata if i needed to…. my fund manager inists that they frequently take and split these checks into part ira and part roth. still not confident though
CDogg,
The point of the pro-rata rule is that it applies to each distribution BASED ON how much was in the entire 401(k). If 10% of the account is after-tax, then 10% of every distribution, whether it’s $1,000 or $200,000, is after-tax. Think of it like putting 10% creamer in your coffee and stirring it. From that point forward, it doesn’t matter how much you pour, every amount that comes out will be the same mixture of part-creamer and part-coffee.
The confusion about this rule, in essence, is that it depends on WHERE THE MONEY GOES. If you get a check and put it in your bank/brokerage account, it’s after-tax first. If you take the check and put it into another IRA (as a rollover), it’s pro-rata. The destination changes the treatment.
The 401(k) assumes by default that it’s going to go to a bank/brokerage account, and that it will be after-tax (as that’s the only way it was done decades ago when these rules were first written, before Roths were even invented). But if you really DO complete a rollover, it’s not after-tax anymore, it’s pro-rata, regardless of what the 401(k) provider THOUGHT it was going to be before they knew what you were going to do with the money.
The bottom line: what the 401(k) providers THINKS you will do with the money is not binding. What is binding is what you ACTUALLY do with the money. And if what you do with the money is roll it over to an IRA (or Roth IRA), it’s a pro-rata distribution.
– Michael
Thanks Michael. i can definitely see the different “opinions” you’re talking about. the bogleheads group seems to think they have it very figured out to where they only need to worry about the taxable gains in the post tax sub account. they have quite a little movement there.
the method they are using currently/mostly is to move the entire post tax sub account to roth, and just pay the taxes on the gains portion, as is shown on the 1099 given for the distribution. this actually seems logical, as you are just entering what the 1099 tells you.
Michael,
(I thought i posted here yesterday but i don’t see it. Pardon me if i’m duplicating…). How do you best unwind an after tax 401k piece that was put into a Roth IRA. We are still before the extension deadline. Do you simply withdraw the amount from the Roth plus earnings and tell the custodian it was placed there in error? Do you have to recharacterize it into the traditional IRA and file the 8606 and track basis forever. Would rather just have the cash.
IRS has issued a new guidance that may allow tax friendly after tax rollovers from a 401k to a Roth IRA. Please see http://www.irs.gov/pub/irs-drop/n-14-54.pdf
Indeed, I have a full article discussing the new rules and their implications written up. It will be out in just a couple days! 🙂
– Michael
Is it safe to assume that any conversions from 401(k)’s to IRA’s made after September 18th will be interpreted by this guidance?