Roth Conversion of After Tax 401k Dollars
I have two situations with slightly different circumstances…
A terminated employee has $200,000 in his 401k from After Tax contributions and another $100,000 from company match. He has never made a pre-tax contribution and I do not yet know how much of the $200,000 After Tax account is contribution as opposed to earnings. Is he permitted to rollover just the $100,000 pre-tax company match portion to a TIRA and then convert the other $200,000 to a Roth IRA so he can avoid paying taxes on the $100,000, or he is subject to the pro-rata rule on the entire amount. I assume the company will have to give him a breakdown of the $200,000 After Tax account so he knows how much is contribution and how much is earnings? He is only 44 years old so I think a Roth Conversion of some or all his 401k dollars will make a lot of sense.
A 61 year old client is retiring in 2011. He has 1.2M in his company 401k plan, of which 100k is in his After Tax account. Similar to the question above, can he take an in-service withdrawal of just the 100k after tax dollars and convert it to a Roth IRA and pay no taxes and then next year when he retires, rollover the remaining pre-tax 401k balance to an IRA?
Thank you as always!
Permalink Submitted by Alan Spross on Thu, 2010-08-12 00:37
Both situations reflect the current state of uncertainty the IRS has created with respect to isolation of basis in these plans. Until the IRS completely clarifies the extent to which the pro rata rules must apply, the situation remains murky. The only sure fire way to isolate the after tax basis is to have fund distributed to the employee less the 20% mandatory withholding on the pre tax amount, and then the employee must have the money to replace the withholding to complete the rollovers. Employee would first then roll the full pre tax amount to a TIRA, and then the after tax amount to a Roth IRA.
This may not work for a direct rollover because Sec 402(c)2 of the code specifically states that the funds must first be distributed to the employee and the employee must do the (60 day) rollovers. The American Benefits Council has now made 3 requests to the IRS pleading for clarification of the confusing Notices they issued in 2009. Plan administrators frankly are not sure what they should do.
Permalink Submitted by Jonathan Sard on Thu, 2010-08-12 18:36
So to place it safe, for the first person, we can convert all $300,000 directly to a Roth and then find out from his previous employer how much of his after tax account was from contribution and then just pay the tax on his gains and employer match portion of his account?
Permalink Submitted by Alan Spross on Thu, 2010-08-12 18:51
Yes, you can always convert the entire account. The pro rating problems only occur when you want to direct only part of the total distribution to a Roth IRA. Note that earnings from the contributions, the company match and earnings from the match all go into the pre tax balance. Only the actual after tax contributions themselves are considered after tax.
The actual amount of after tax contributions will be tax free. Company match and all earnings will be taxable. It is odd that he NEVER made pre tax contributions, so you should verify if that is correct. For example, if the total plan value is 300k and 200k was the after tax amount, he would only be taxed on 100k. Moreover, if the conversion is done this year, the income from the conversion would be 50k in 2011 and 50k in 2012 UNLESS he opts to report the entire 100k in 2010. The conversion can be done with a direct rollover to a Roth IRA from the plan. If any of these funds go into a TIRA and he has other TIRA accounts, the pro rate rules will then apply to conversions and his taxable amount would go up. So a direct conversion would be the way to go IF it is to his advantage to convert at all.
He will still have the option to recharaterize all or part of this conversion until 10/17/2011. If he does, the recharacterized funds must go to a TIRA. They cannot go back into the plan. But the point is that he will still have the option to recharacterize for any reason that develops.
Permalink Submitted by Jonathan Sard on Thu, 2010-08-12 19:02
Thanks Alan. He did confirm that all 200k is after tax and that the 100k is all company match because I was surprised as well that he never made a pre tax contribution. In fact, he thought he was making pre tax contributions all along! He is a brand new client and I now have him going back to the administrator to find out how much of the 200k after tax account is from contributions and how much is from earnings. My hope is that most of the 200k is from contributions so he won’t have to pay too much in tax on a conversion.