After-tax 401k $ & Roth Rollover
I have a client that has a 401k plan that doesn’t stop his contributions when he hits the max. Instead the contributions get put into a after-tax account. The after-tax account has grown to over $50k. I spoke with the plan administrator about the options for moving the after-tax money out of the 401k and into something with more investment options. They said that one of the options is to rollover that money into a Roth or just take the after-tax contributions out and roll the after-tax earnings into an Trad IRA. They cautioned me that neither of these maneuvers has been ruled on by the IRS. Has anybody experienced a similar situation and what was your experience? I am wondering if I do one or the other – what is the worst thing that could happen if the IRS doesn’t like it.
Permalink Submitted by Alan Spross on Wed, 2010-12-15 22:03
The plan rep is correct that there are unresolved IRS issues involving “isolation of basis” when doing Roth conversions. The IRS issued confusing statements in Notices released in Oct, 2009 and have not responded to pleas for clarification from major employee benefit firms for over a year now. Note the employer plans similarly do not have the direction on how to properly complete their 1099R reporting the distributions. You can find probably 50 or more discussions of this problem over the past year on this forum.
It may be worth the gamble that client will be able to effectively isolate the basis, particularly if this can be completed before year end.
1) Has client separated from service?
2) If not, does the plan restrict access to distributions of only certain portions of the balance?
3) Does client have the money to front the 20% withholding on the pre tax amount in the plan until he gets his tax refund?
Please advice and then we can come up with the worst case scenario.
Permalink Submitted by Scott Nelson on Wed, 2010-12-15 22:57
The client is not separating from service. Money is not really an issue since he is highly compensated but the administrator assured me that the client was free to take the after-tax money out at any time. If he just wanted to spend it there would be cap gains tax on the after-tax earnings. No 10% penalty.
The administrator makes it seem like an after-tax IRA hiding in a 401k, but without all of the IRA rules how can it be treated as such?
If you are scratching your head as well, can you point me to the conflicting IRS statements on the matter?
I apologize for going down a well-worn path but the search engine for this forum is inadequate. I tried a couple searches and the search engine told me there were too many entries involving “after-tax” “401k” “Roth” “rollover” to give me anything. This forum probably needs to be broken up into more topics although it wouldn’t make a bit of difference to the already confused.
Permalink Submitted by Alan Spross on Wed, 2010-12-15 23:51
Since this would be an in service distribution, any pro rating of the basis is limited to the funds he is eligible to take out. But the way the plan issues the 1099R will most likely trump these other concerns. One way to avoid the unresolved issues here is to request a distribution of the after tax amount and the earnings. There will be 20% withheld on the earnings, but if client has the money to replace the withholdings until his tax refund, he could:
1) Receive the distribution less withholding
2) First, roll the pre tax amount over to a TIRA
3) Then roll the after tax amount over to a Roth IRA tax free.
He would have to replace the withheld amount in some combination over steps 2 and 3 to complete those rollovers. This is clearly allowed in the tax code in Sec 402(c)2 for distributions made to the employee, but may not work if attempting to do a direct rollover where employee does not receive the funds.
Note: If he kept the pre tax earnings amount, the tax on that would be at ordinary income rates. Cap gain rates would not apply.
The 10% penalty would apply if he did not roll the funds over to a TIRA or Roth IRA unless he is 59.5. Perhaps he is 59.5, don’t know why else they indicated no 10% penalty.
If he proceeds per above, he might get two 1099R forms or a combined form including the 20% withholding (only on the pre tax amount), and the taxable amount would show in Box 2a including the withholding. The rest would be tax free and would be the amount he has rolled into the Roth IRA by that time.
Since there will be no taxable amount for this conversion, there is no rush to complete it this year as there is no income to be split between 2011 and 2012.