After Tax 401(k) Rollover to ROTH IRA
If a client’s AGI is above the $100,000 limit and is not eligible to roll his after tax 401(k) funds directly to a ROTH IRA. Can we separate the after tax from the pre tax with separate IRA’s and then in 2010 convert the original post tax amount to a ROTH IRA? If so what would the tax issues be under the current law????
Thanks
Permalink Submitted by Alan Spross on Fri, 2008-05-23 22:22
Distributions from the 401k must be pro rated between after tax and pre tax amounts EXCEPT for pre 1987 after tax amounts. If the plan separately accounts for these amounts, they could be rolled over to a TIRA and then converted in 2010 when taxpayer is income eligible. While that conversion taxation is still subject to the pro rate rules, the tax free share would be very high if he has no other TIRAs and also would certainly be higher even if he had other IRAs if the current 401k balance was left in the employer plan except for the pre 87 after tax contributions.
Many advisors assume that in 2010 a direct Roth conversion will be allowed for after tax amounts while the pre tax amounts go to a TIRA. This would make the direct Roth conversion totally tax free. However, the IRS has not clarified this to date, and it would be better to wait until they do. This should certainly be clarified prior to 2010, so it might be wise to wait before tranferring to a TIRA. Once the entire 401k is in various IRA accounts, they all must be considered as one total account for purposes of the pro rata rules.
Permalink Submitted by Jeffrey Smith on Fri, 2008-05-23 23:48
so if the client wants to rollover the pre tax and separate the poset tax now he must roll the pre tax over and the post tax must move to a taxable account. The plan provider does account for the amounts (pre and post tax) If he separated the two parts to separate IRA’s when he went to convert the IRA (2010) with the post tax portion he would only need to pay taxes on the growth in that IRA and the original after tax amount is tax free correct? He then as 2 years to pay the tax due also correct???? Just trying to clarify if it is best for him to simply move the after tax funds to a retail account or wait to convert to a ROTH in 2010
Permalink Submitted by Alan Spross on Sat, 2008-05-24 02:04
In order to avoid introducing too many variables, let’s assume there is no pre 1987 after tax amounts in the plan, therefore all amounts that are distributed come out pro rated.
If the after tax amounts are not rolled over they cannot be converted to a Roth later on. If they are rolled over along with the pre tax amount, the taxpayer files a Form 8606 to report the after tax basis in the IRA. Regardless of how many IRA accounts he has, any conversion done from any of the accounts has the same tax free portion. Taxes are paid only on the pre tax share including all earnings on both shares.
For example, in 2010 if all his traditional IRAs adjusted for the converted amount total 300,000 and he rolled over 15,000 of after tax contributions, then 5% of any converted amount is tax free (15k/300k). If 40,000 is converted, then 38,000 is taxable. He could either report 19,000 each on his 2011 and 2012 returns, OR opt to report the entire 38,000 on his 2010 return.
In summary. IF it is to his benefit to increase his Roth assets, then he should rollover the after tax amounts because he can then get them into a Roth tax free. If there is no conversion planned, then it does not make much difference whehter he rolls over the after tax amount or just invests it in a taxable account to generate LT gains or qualified dividends taxed at the lower rate.
If he has considerable pre 1987 after tax amounts, then the strategy can change because he can have these distributed alone and my also be able to convert them directly from the 401k to a Roth IRA tax free once the IRS clarifies that this can be done. It may be worth it to wait until this is clarified if he has the pre 1987 amounts of any value.