401k After-Tax Contributions Deposited to Roth IRA as Roth Conversion?

Submitted by David Dunn on Thu, 2014-03-20 17:53

Background:
We have clients working for a company that allows participants to separate after-tax contributions from the total 401k balance when performing a rollover. The after-tax portion is provided to the participant in a separate check payable to the participant. The remaining rollover balance is provided by check; payable to the IRA custodian.

Question:
Can the check representing the after-tax contributions be deposited into a Roth and coded as a Roth conversion? When we have seen this done, the 401k custodian has produced 2 – 1099s, one coded as a Qualified Rollover and the other showing a distribution; however not taxable. The IRA and Roth IRA custodians have subsequently prepared 2 – form 5498s indicating the contributions were a Qualified Rollover and Roth Conversion respectively. We have seen this done many times and are questioning whether this is permitted.

Additionally, the company allows the participant to distribute after-tax contributions at any time (no age restrictions, etc.). In that case, participant are able to request two checks like the example above, one check representing the after-tax contributions payable to the participant and the second check representing pre-tax growth associated with the after-tax contributions payable to a Traditional IRA custodian. Please advise.

Thank you.

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Permalink Submitted by Alan - IRA critic on Thu, 2014-03-20 18:10

These procedures have been followed without IRS challenge in recent years despite IRS Notive 2009-68 indicating that basis should be pro rated between the IRA types when doing rollovers. Until the IRS acts further, I would not hesitate to split the rollovers as indicated. Usually when there is an after tax sub account with only a small amount of earnings included, clients may wish to do a direct rollover of the entire balance to a Roth IRA, even though taxes will be due on the earnings component. No sense in taking risk of IRS issues when the earnings are very small in the after tax sub account.
For those wishing to reduce the risk further, they could request a full distribution to them, replace the 20% withholding on the taxable portion, and roll the pre tax amount to a TIRA first, then roll the balance to a Roth IRA. There is less risk using this method because it is protected by Sec 402(c)(2) which states when a distribution is made to the employee, the first dollars rolled over are deemed to be the pre tax amounts.