Converting a 401k to a Roth
I have been working with clients this year heavily on converting after-tax contributions in 401ks directly to Roth IRAs. The one company plan that we do a substantial amount of work with requires that the retirees also take out the associated pre-tax earnings related to the after-tax contributions. The strategy has been to have them cut two checks (after-tax and pre-tax). We take the after-tax and deposit it directly into a Roth. The pre-tax dollars go into a rollover IRA. Most (like 99%) don’t have other IRAs to worry about. My question is that if I wanted to start converting the pre-tax dollars in the same tax year, am I going to get into a basis allocation issue with the after-tax dollars we already converted?
Permalink Submitted by Alan Spross on Mon, 2010-08-16 20:23
You may have seen the extensive posts on the “isolation of basis” quandry that awaits IRS clarification of their “pro rate” Notices of 2009. At this time, the after tax conversions that you have already done may not be completely free of risk that the IRS will require custodians to change their 1099R procedures to invoke pro rating of the basis. The only sure fire way to accomplish this is by indirect rollovers done by the client, and do complete those rollovers the client must have the funds to replace the IRS mandatory 20% withholding on the pre tax portion.
I would guess that 2008 and 2009 after tax conversions are fairly safe right now because the chaos resulting from the IRS requiring revision of prior 1099 R forms would be devastating. But 2010 is the really big conversion year and the IRS is under pressure to rule on the pro rate issue. The Amercan Benefits council has sent 3 letters to the IRS pleading for them to clear this matter up. Your clients will probably be OK, but no way to know for sure at this point.
With respect to your question, if a client started to convert the direct rollover TIRA to a Roth following the after tax conversion directly from the plan, such a conversion would not itself trigger a problem, and the conversion would be reported on the 8606 as fully taxable. HOWEVER, if the problem cited above materialized, then part of the Roth conversion would be taxable and the TIRA would have received it’s share of the basis from the after tax contributions. If that happened, doing the the IRA conversion would dilute the problem caused by the adverse IRS ruling because the basis in the IRA would then be tax free for the IRA conversion. If a client converted everything in the plan that was distributable, the pro rate issue would disappear. He would simply be taxed on the pre tax amount only. Therefore, an IRA conversion would not itself jeopardize the original strategy, and if the IRS ruled adversely on pro rating, it reduce the consequences of that ruling. The only downside would be that the total tax bill would be higher, but the two year deferral will help with that.
I assume that the company plan provisions for in service distributions does not allow for distribution of employee pre tax deferrals or company matching contributions, just after tax contributions and their earnings. This is a benefit since any pro rating that the IRS requires would be limited to only those assets that were distributable. It would not factor in the other pre tax assets.