401K Rollover to Roth IRA – Problem?
So, I am confused by something my 401k company told me before I rolled over my after-tax $$ to a Roth IRA and pretax amount to
TIRA.
My initial after-tax contribution to the 410k was about 10000. I have had this 401k for a LONG LONG time. This amount grew from 10000 to about 46000. and pretax amount from 5000.00 to 35000.00
I was told that I can transfer the full 46000 (which they list on their statement as being my after-tax portion of my full 401k balance) to the ROTH, without a problem. Now, I think that the EARNINGS on the initial after-tax 10000 contribution, which would be 46000-10000 = 36000 are taxable and that I shouldn’t have transferred the earnings into the ROTH if I don’t want to pay taxes on that.
So, question is do I have to pay tax on the earnings? Will the IRA company report my after tax amount as 10000 on the 1099 form, or should they report 46000? OR should I tell my ROTH IRA company to correct this and rollover to roth ira 10k and the balance 36000 to TIRA?
If they report 10000, and since I already transferred 46000 what are my options / what do I need to do? Recharacterize the 36000 to a TIRA? OR?
Thanks in advance!
Permalink Submitted by Alan Spross on Fri, 2008-10-31 04:14
Short answer – I think you are stuck with the tax bill on the 36,000 unless you recharacterize the entire Roth conversion to a TIRA account.
The original error was not to make the TIRA transfer for 71,000, which is what you originally intended to do. That would have left the 10,000 of after tax basis in the plan to be converted tax free to a Roth IRA.
The IRS has not published detailed regulations on the new direct Roth transfer, so I could be surprised. However, I arrive at this conclusion based on the changes made in the 2002 Job Creation and Worker Assistance Act (JCWAA). This legislation installed an order between post and pre tax amounts in rollovers from employer plans. The first dollars rolled over are always the pre tax dollars. Therefore, when 46,000 was left in the plan after the direct TIRA rollover, the first 36,000 converted to the Roth was pre tax, and the last 10,000 was the after tax amount. As it stands, you would owe taxes on that 36,000 as you suspected.
More bad news – you can indeed recharacterize the conversion not back to the 401k, but to a TIRA account. The adverse part of this is that in recharacterizing, it is logical to expect that the first dollars out of the Roth are the last dollars in. That means that the after tax dollars would go first to the TIRA, and the 36,000 of pre tax dollars second. This is the exact opposite of what you would want, in desiring to get to a tax free conversion of only $10,000.
The normal pro rate rules of basis used in converting from a TIRA do not apply here. When an IRA conversion with basis is made, both the conversion and the recharacterization are made on a pro rated basis between post tax and pre tax dollars. Those recharacterizations are also a reversal of how these dollars were applied in the conversion.
Again, I may be wrong, and the IRS could come up with a different application for the recharacterization, but since the Regs are not yet issued, I do not know how the Roth custodian would report it. Therefore, you may want to hold on before acting further to see if the IRS comes up with something more attractive than what I just posted. The recharacterization deadline is not until 10/15/09, and the IRS should be issuing detailed Regs long before that.
Of course, if you do not mind paying taxes on the 36,000 of pre tax dollars to get 46,000 into the Roth IRA, then there is no problem. Another benefit of waiting is to see what your earnings turn out to be on the total conversion to determine if you want to recharacterize.
Permalink Submitted by fairira on Sun, 2008-11-02 06:22
Alan,
You noted that “the 2002 Job Creation and Worker Assistance Act (JCWAA) … installed an order between post and pre tax amounts in rollovers from employer plans. The first dollars rolled over are always the pre tax dollars.”
Q.: Does this order also affect the tax basis when an employee elects NUA on some shares in his employer plan and rolls over the remaining shares to a TIRA? I.e., should the employee do the latter rollover first so that his subsequent distribution of the desired NUA shares would include his post tax shares?
Permalink Submitted by Alan Spross on Sun, 2008-11-02 19:54
That’s an excellent point, and I have not seen it addressed in articles on utilizing NUA opportunities with after tax plan contributions.
According to the following link, doing the IRA direct rollover first should assure that the plan assigns the remaining post tax allocation to the NUA shares, and that would directly reduce the current taxable cost basis for the LSD. However, it would have no effect on the cost basis of the NUA shares for purposes of the subsequent sale of those shares reported on Sch D.
http://www.mhco.com/Library/Articles/2004/ARoll_Portability_080504.html