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SUBJ: In-Service Withdrawal of After Tax 401K Funds into Roth and Traditional IRAs
I would like to get a ruling from the IRS as to any tax consequences of doing an In-Service Withdrawal of “after tax” 401K contributions (not Roth 401K contributions) rolling them over from the custodian to custodian into a personal Roth IRA for the basis and a Traditional IRA for the gains on the after tax 401K portion. There seems to be a lot of confusion on this subject. I am 54 years old. My company’s 401K plan allows “In Service Withdrawals” of after tax 401K funds as a non-hardship withdrawal or a rollover into Roth IRA for the after-tax “basis” and a Traditional IRA for the “gains” on those after tax funds. My assumption is that once the funds are in the Roth IRA, the future gains on that account as well as the basis can be distributed tax free once I reach 59.5 years old and the funds have been there for five years. Also, I assume that the funds rolled into the Traditional IRA will be taxed as regular income once distributed. Is this correct, or am I missing something?
Frank Orner
Permalink Submitted by Alan Spross on Wed, 2011-09-07 20:08
The IRS has not been very clear regarding “isolation of basis” issues. While their Notices in 2009 indicate a general requirement of pro rating distributions of basis between the Roth and the TIRA, there is no 1099R reporting procedure in place to properly identify how much of the basis goes where. The IRS has also not commented on what amounts the pro rating should apply to.
If only a portion of your plan balance is eligible for distribution, such as after tax contributions and their earnings, any pro rating should only apply to those balances and should not include your pre tax deferrals that are not eligible for distribution until a later year. If your earnings are small, you should just have the total transferred to a Roth IRA and this conversion would be mostly tax free, with tax only on the earnings.
Now what you propose here is to “isolate” the after tax amounts to the Roth IRA and the pre tax amount to the TIRA. If you try to do this by direct rollovers, you open up the chance that the IRS could require pro rating rather than isolation of the basis. But there is a way around this where the tax code itself supports isolation. It works like this. Do NOT request a direct rollover, but rather a distribution to YOU after which you will do your own rollovers, first the pre tax amount to a TIRA and then the remainder to the Roth IRA. Because the amounts were distributed to you (employee), section 402(c)2 of the code says that the first dollars you roll over are deemed to be the pre tax amounts. That is why you do the TIRA rollover first. There is one inconvenience in doing it this way however. The plan must withhold 20% of the pre tax amount to the IRS. That means that you must have the cash available to replace the withheld amount in order to fully complete the two rollovers. Of course, you will get the money back with a tax refund when you file because your rollovers are both tax free.
Your interpretation of the TIRA and Roth taxation is correct when you finally take distributions. You describe a tax free fully qualified Roth IRA, but the TIRA distributions will be taxable.
Permalink Submitted by Peter Lingane on Thu, 2011-09-08 15:07
Creative, Alan.
I assume that you are suggesting two separate rollovers. Fortunately the once a year rollover rule does not apply to qualified plans.