In Plan Roth IRA Conversions

Submitted by Deanna Bingley on Thu, 2019-09-26 13:35

We have a client that has a large balance in his 401(k) plan – roughly $1 million. He is a director at his company and we suggested that he request to have the ability to make After Tax contributions to his 401(k) so that he can one day convert them to a Roth IRA. His plan actually added that capability. Upon our review of the plan rules we were surprised to read that he can automatically convert after-tax conversions the day after they are made without any regard to the balance in his pre-tax account. It seems that this essentially allows the participant to contribute up to the maximum amount to the pre-tax 401(k) account in addition to allowing up to the government limit to the Roth (albeit with an added step and little to no tax consequences).

In our experience, there has always been pro-rata treatment when converting to a Roth IRA and there is a balance in pre-tax and after-tax money?

Has anybody had any experience with this?

Thank you!



Submitted by Alan - IRA critic on Thu, 2019-09-26 14:46

  • This is a great opportunity for the client.  After tax 401k contributions are made to a separate sub account per IRS Code Section 72(d)(2). Balance in this account can be distributed without regard to the rest of the 401k balance. The only question is how often the plan allows these distributions, whether they require an IRR, or if they allow direct rollovers to a Roth IRA. This is likely a large employer because the automatic IRR sweep is not typical in smaller plans and is a very desirable feature. At year end client will get a 1099R adding up the total IRRs for the year. There might be a miniscule amount of earnings generated on the contributions before the IRR is done which will be taxable as shown in Box 2a of the 1099R.
  • One pitfall here is that the after tax contributions are subject to the ACP discrimination test if the client is an HCE. This could cause some of the IRR to be unwound. Because of this hassle, some plans will reduce the total after tax contributions allowed to avoid ACP, and also to allow for various company matching provisions from breaching the annual additions limint per Sec 415(c). 
  • Finally, the plan is required to maintain separate accounting for these IRRs done with after tax contributions. Because the contributions are considered “otherwise distributable” mostly without limitations, that charateristic continues after the IRR is done. Therefore, client should still be able to withdraw the IRR and the earnings generated in the designated Roth without waiting for separation from service or some age limit such as 59.5. 

Submitted by Alan - IRA critic on Fri, 2019-09-27 04:55

  • If you roll any part of your Roth 401k to a Roth IRA, there is no current taxation. Any earnings in the Roth 401k are just transferred over to the Roth IRA where they will be treated as Roth IRA earnings. An IRR or a conversion does not count as a regular Roth contribution, nor does it affect the amount of a regular contribution that you can make to your Roth IRA or salary deferral you can make to your Roth 401k.
  • Second question – that would be rare, but is possible. Plans have flexibility to restrict what the IRS allows in some ways. Some plans want to retain employee retirement assets and might only offer IRRs, but no distributions out of the plan. That would be a plan rule, not an IRS rule. You would have to check with your plan administrator to see what your options are.

 

Submitted by ssel on Fri, 2019-09-27 05:03

Ugh, I misstated my first question.  For purposes of the IRA distribution ordering rules, does the amount of the IRR count as a 2019 conversion (partially taxable)?

Submitted by ssel on Fri, 2019-09-27 05:22

Suppose an IRR is done in 2019 and there’s a small taxable amount.  Then in 2020 that after-tax balance (plus earnings) is rolled over to a Roth IRA.  For purposes of the IRA distribution rules, does the amount of the IRR count as a 2019 contribution [edit: meant to say conversion] (partially taxable)?

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Might a plan allow both IRR and after-tax rollovers to a Roth IRA, but not allow the amount from an IRR to be subsequently rolled over to a Roth IRA (before age 59.5 or separation)?

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Thanks 

Submitted by Alan - IRA critic on Fri, 2019-09-27 14:36

Yes, it does. It would be combined with any Roth conversions (TIRA to Roth) in that same year. If a Roth IRA distribution under the ordering rules gets to these Roth rollovers or conversions, the taxable portion of all such rollovers or conversions done in 2019 would come out first, potentially subject to the 10% penalty if under 59.5.

Submitted by ssel on Fri, 2019-09-27 16:11

Thanks!  Your conversions, I mean contributions, are always helpful and appreciated.

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