Converting after-tax portion of 401(k) to Roth
Client age 63 has a $400K 401(k) which contains $50K after-tax; also has a $400K TIRA which contains only $15K after-tax; there is no current Roth account. Desire is to convert up to $200K total to new Roth at lowest tax. My understanding is that any or all of the 401(k) may be rolled over to a Roth without consideration of the existing TIRA. If so, then 350/400 (87.5%) would be pro-rata taxable. Is that correct? Also, is it possible to convert/roll only the after-tax portion of the 401(k) to a Roth?
Permalink Submitted by Alan Spross on Wed, 2010-09-01 21:31
Correct. A direct conversion from a qualified plan to a Roth IRA is not affected in any way by the traditional IRA mix of non deductible contributions. Generally, for a partial conversion it is better to convert amounts from the account with the highest % of basis, ie the 401k in this case.
There is considerable uncertainly regarding pro rate requirements vrs the ability to isolate the basis in a qualified plan. It can clearly be done under Sec 402(c)2 using an indirect rollover to the employee, but doing it with a direct rollover apparently invokes pro rating according to IRS Notices issued in 2009. Therefore, it cannot be said with certainty that this 401k can be distributed such that the 350k goes to a TIRA and the 50k to a Roth IRA. There would be no taxes due in such a transaction, and it gets the basis into a Roth much quicker. The Employee Benefits Council has now written to the IRS 3 times pleading for them to clarify their prior rulings. So far there is no answer.
Doing the indirect rollover mentioned above, the employee must replace the 20% withholding ($70,000) to complete the rollovers. If employee can do that, he can definitely roll the 350k to a TIRA using a 60 day indirect rollover and then roll the remaining 50k to the Roth IRA. He gets the withholding back when he files next spring. Beyond that, the issue is unresolved.
You can find dozens of post on this issue on this site by doing a search.
Note: There is an exception for pre 1987 after tax contributions. These can be distributed (converted) separately without pro rating if the client’s statement shows a balance of such contributions. That might be something to consider, ie how much of the 50k is pre 1987?
Permalink Submitted by Paul Monaghan on Mon, 2010-10-11 02:15
Thanks Alan for keeping (or setting) me straight-
First, none of the after-tax is pre-1987. After scouring this forum including the Fairmark article, I have a follow-up question re the below approach.
First, carefully following Strategy-3 from the Fairmark article, indirectly rollover all 401(k) assets, creating a combined TIRA value of $750K plus an initial $50K Roth. It’s understood that 20% of the $350K pre-tax portion of the rollover will be withheld. Then, still within 2010, do an additional conversion of $150K of the now-$750K combined TIRAs, which still has $15K after-tax. The taxable portion of this conversion would be 735/750 and can be split between 2011 and 2012. Is anything invalid or IRS-risky with the approach?
Permalink Submitted by Alan Spross on Mon, 2010-10-11 02:44
No. This is the risk free method of isolating the basis and will work according to your post. Of course the client must come up with 70k to replace the 20% withhholding until the IRS issues a tax refund upon filing the 2010 return.
Doing the above by a direct rollover would involve the risk of the IRS requiring pro rata treatment, and right now it is not possible to quantify that risk. If he has the 70k, this is the way to go to get the 50k into the Roth IRA tax free.
Note that any distribution from the Roth prior to 2012 of any of these two amounts of conversion dollars will trigger an acceleration of taxes due from the amounts that would have been deferred to 2012 first and 2011 second.
Permalink Submitted by Paul Monaghan on Mon, 2010-11-29 21:16
I’m sorry for re-asking a question that you’ve already answered. But while on the verge of requesting full 401(k) distribution in order to do the “risk-free” indirect rollover, I came across a June, 2010 Kitces Report that reaches a different conclusion. Using the Fairmark Strategy 3: first indirectly rolling the pre-tax amount to a TIRA, then converting the after-tax amount to Roth within the same 60-day rollover period- it indicates that since the entire distribution will have been rolled over, the pro-rate rules apply. Their reasoning is that the broad application of IRS rules assign a pro-rata allocation of cost basis amongst the entire 401(k) distribution. Their end result is that “…there no longer appears to be any way to separate the pre- and after-tax funds so that the amounts converted are only and entirely attributable to after-tax funds.”
1- Am I overlooking something relative to “risk-free”?
2- Does it make a difference whether all or part of the after-tax amount is converted to Roth?
3- Assuming the strategy is still pursued, which would include filing as soon as possible to get the earliest refund of the 20% tax withholding, could a recharacterization still be done up to the October deadline by filing an amended return?
Thanks-