Tax-Free Roth Conversions of After-Tax Plan Funds

Submitted by Jason Hochstadt on Sun, 2014-11-02 21:00

Hello,

As a subscriber to Ed Slott’s IRA Advisor I read with interest the Oct. issue article entitled, “IRS Authorizes Tax-Free Roth Conversions of After-Tax Plan Funds.” I had a few questions per the article as well as a few other articles I’ve read on this topic recently:

1. Is it true that a Plan participant wanting to take advantage of this must first contribute the max. pre-tax amount ($17.5k in 2014) into their 401(k)? An Oct. 31st article in The Wall St. Journal, entitled “How to Pump Up a Roth IRA” makes this claim even though this was not contained in Ed Slott’s Oct. issue and an example given in that Oct. issue article (#6) illustrates a woman named Laura who plans on making a full $17.5k deferral into her Roth 401(k).

2. It appears as if the reference to ‘after-tax’ contributions is completely separate and apart from Roth deferrals – which are also made on an after-tax basis. Please confirm that the Plan must specifically permit ‘after-tax voluntary employee contributions’ and, if so, whether or not it is necessary (if it matters) for the Plan to also permit Roth salary deferrals.

3. Suppose a sole owner is adopting a 401(k)/Profit Sharing Plan, utilizing a separate TPA and establishing 2 accounts w/ a brokerage firm that will serve as an investment-only provider: 1 account for pre-tax (Traditional) salary deferrals and company profit sharing contributions and 1 account for after-tax (assume Roth salary deferrals).

Based upon Ed Slott’s article, however, it appears a 3rd account should be established for after-tax voluntary employee contributions since this represents the sole account from which an in-service distribution may be taken in order to convert these funds into a Roth IRA. Is this correct?

It should be very easy to keep track each year (as is required for the IRS) the contributions into each account type, along with any earnings/losses. I know that any distributions would be done on a pro-rata basis between pre-tax and after-tax funds.

4. Isn’t there an advantage to keeping the funds in the 401(k)/Profit Sharing Plan longer (e.g. until retirement, for instance), relative to converting to the Roth IRA as illustrated in Ex. #7 in Ed’s Oct. issue because the 401(k)/Profit Sharing Plan, governed by ERISA, offers greater creditor protection relative to IRAs, which are subject to state law and have limits on how much may be creditor protected depending upon whether the monies are contributions, rollovers, etc.?

5. Forgetting after-tax voluntary employee contributions for the moment. Assume a participant makes Traditional and Roth salary deferrals into 2 separate accounts for his 401(k)/Profit Sharing Plan (and any profit sharing contributions are directed into the Traditional account). Say the employee retires at 60. Is there anything stopping him from then doing a direct rollover of each into a Traditional IRA and Roth IRA, respectively – with the Roth Rollover IRA not subject to income taxes or RMDs?

Is the only benefit from Notice 2014-54 that, in addition to being able to make Roth salary deferrals, a participant may now also make additional after-tax contributions which can ultimately end up in a Roth Rollover IRA?

6. I want to confirm that, in terms of the annual defined contribution limit ($52k in 2014), per Ed’s Oct. issue article a Plan participant may make $17.5k in Roth salary deferrals and, to the extent the employer does not provide any profit sharing or matching contribution, but does allow for after-tax voluntary contributions, the employee may make an additional $34.5k in after-tax voluntary contributions even though the elective deferral limit is presently $17.5k.

How do ‘after-tax voluntary employee contributions’ get coded on a W-2? Just like Roth salary deferrals?

Based upon the article, it would appear that any ‘Roth salary deferrals’ and ‘after-tax voluntary employee contributions’ should be segregated in different accounts if possible.

7. Comparing one Plan wherein a participant’s accounts are commingled together but the different money sources are tracked with the investment firm, versus another Plan wherein a participant has a separate TPA and separate and distinct accounts for the pre-tax, Roth and after-tax voluntary employee contributions, does the latter make the tax-free Roth conversion of after-tax plan funds easier/simpler/cleaner from a record keeping perspective?

8. Lastly, the above can become cumbersome just in terms of the # of accounts required. Is there any reason why pre-tax salary deferrals into a 401(k)/Profit Sharing Plan cannot be combined in one account with company profit sharing contributions since both are being made on a pre-tax basis (either by the participant or the company)?

Thank you.

Jason



Submitted by Alan - IRA critic on Sun, 2014-11-02 23:51

  1. No, the Roth rollover can be done without making any contributions in the current year. Many of these rollovers will be done after separating from service. The Journal example just illustrates how plans that offer employees an after tax sub account allows employees to make after tax contributions even though they have maxed out their 17.5 elective deferrals, but maxing out is not required except possibly in a few cases where the plan itself requires that.
  2. The plan can include an after tax sub account even if it does not offer designated Roth deferrals. After tax sub accounts were first offered many years ago. It is correct that while both the Roth and after tax contributions are both post tax, that is all they have in common as the after tax sub account is part of the pre tax account.
  3. The after tax sub account is just a separate portion of the pre tax account. The designated Roth is a separate account on it’s own, but not a sub account. Look at the pre tax account has having two parts, and the Roth having only one part.
  4. Not necessarily. Some plans have high expenses ratios and many states provide complete creditor protection for IRA accounts. Depends on your exposure to creditors, the amount at risk, and what state you live in.
  5. Nothing prevents this. Other than leaving the assets in the plan, it is the only logical thing to do. Some plans like the TSP might not let you roll out one section without the other.
  6. That is correct. But if there is matching, there might also be forfeitures, so plans with a match will often reduce after tax contributions such that the match and forfeitures plus after tax contributions cannot possibly exceed the 52k total.
  7. Many plan administrators present the separate accounts so they appear combined when looking at statements or on line summaries, but legally they must be kept separate at some level of the plan record keeping. This saves them money on their account platforms, but is is misleading and I am surprised it is allowed. Plans that do this also require the same investments for each separate portion of the plan. For individual plans, the separate TPA approach would be more clear to the plan owner with respect to separate account breakdown.
  8. Those two DO go into a single account. Profit sharing goes into the pre tax account, but the plan still must keep records of how much was elective deferrals. That is just a sub total within a single account.

Submitted by Jason Hochstadt on Thu, 2014-11-06 14:11

Hi Alan, Thanks for your reply above.  It’s now more clear that the after-tax voluntary contributions represent a sub-account of the pre-tax bucket.  It seems as if it would be much easier and cleaner if the after-tax voluntary contributions could be in their own, separate account, rather than commingled with pre-tax monies and then segregated into a separate sub-account since all of the funds are in one overall account.  Alas, this must be prohibited by IRC rules and regs. regarding qualified plans.Since it’s impossible to know the tax rules in the future (e.g. what if Roth monies end up taxed at some level and not grandfathered although it may seem unlikely and improbable, etc.), it seems simpler for someone, if a sole owner of a pass-through entity with a 401(k)/Profit Sharing Plan, to the extent they want both pre-tax and after-tax funds contributed to max out the Roth 401(k) portion of $17.5k in 2014 ($18k next year), with the matching contribution (of up to $34.5k this year for a $52k annual addition) being directed into the pre-tax account.  The matching contribution is a reasonable and necessary business expense so the pass-through entity (e.g. S. Corp) gets to deduct it on its taxes so the owner has less K-1 income, while the owner is also getting after-tax monies invested in order to provide tax diversification.  Then there would never be any after-tax voluntary employee contributions which, while offering potential benefits as noted by Ed’s article, does significantly complicate matters.  The ‘after-tax’ voluntary employee contributions would seem to be applicable only in the case of someone completely unconcerned about future changes to tax laws and distribution rules for Roth IRAs down the road, along with that individual participant having significant after-tax savings who is able to forego any kind of a deduction at the personal or entity level despite likely being in a very high marginal income tax bracket for Federal and potential State income tax purposes – thereby enhancing the value of a potential deduction.Lastly, by doing in-service distributions on a periodic basis (e.g. every year or few years), since only after-tax contributions would be eligible, even though you’ve got the pro-rata rule for the 401(k)/Profit Sharing Plan (similar to doing a Roth IRA conversion if there is pre-tax and post-tax monies), this would minimize the extent of any income taxes owed.  What I was also unaware of, as per Example #7 of Ed’s Oct. issue article, is any earnings on the after-tax voluntary employee contributions are treated as pre-tax sums even though they are dervied from the after-tax voluntary employee contributions – which appears to be nonsensical.Feel free to let me know your thoughts regarding the above.  Thank you.     Jason

Submitted by Alan - IRA critic on Thu, 2014-11-06 23:23

  • Remember, after tax sub accounts go back at least to 1986, fully 12 years before designated Roth accounts were created by Congress. This report explains some of the background and basics of the after tax sub account. http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/separate-subaccount-treatment/
  • But since designated Roth contribution limits are the same as pre tax elective deferrals (17.5k), the after tax sub account remained useful as it provides a way to make additional employee contributions up to the annual additions limit (52k), whether the employee otherwise elected pre tax or designated Roth deferrals for the 17.5. Further, the after tax sub account is open for distributions prior to age 59.5 or separation from service and is therefore much more accessible than the elective deferrals. Notice 2014-54 is helpful for isolating basis not only for a total distribution after separation, but also for in service distributions such as those made from the after tax sub account periodically before earnings accrue in that account. Obviously, the sooner there after tax contributions can be rolled into a Roth IRA, the sooner the earnings generated will be eventually tax free whereas they will not be tax free when generated in the after tax account.
  • I would not be that concerned about massive bait and switch tax changes for Roth IRAs. If the national deficit got so bad that Congress had to blatantly renege on the promised tax benefits of the Roth IRA, we would have much more serious problems than that. Even for those who actually think the law will be changed, the current balance would be grandfathered, so that makes an argument for contributing sooner while you can. Worst scenario is probably indirect taxes similar to the way muni bond tax free interest goes into AGI to determine taxation of SS benefits. The interest is still tax free, but it increases tax on SS benefits if your benefits are not already 85% included in your AGI. By I don’t see this happening either. We just had the massive Roth conversion incentive in 2010, and remember that Roth conversions is a way for Congress to generate tax revenue on a voluntary basis instead of raising rates. They will likely continue to promote conversions and Roth rollovers to produce more current tax revenue, in fact the next change I think that will occur is lifting the restriction on converting inherited IRAs to inherited Roth IRAs. That feature is already available to non spouse beneficiaries of employer plans.

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