Conversion of 401k to IRA

Submitted by Giri Las on Sat, 2009-02-07 22:12

I have a 401k in which almost 90% of my contributions are from after tax dollars. Due to Job loss If I convert my 401k to an IRA (I currently do not have any IRA and my only retirement account is a 401k) what are my options in addressing the after-tax portion (Ex: Can I withdraw the after-tax contribution from 401k without any tax or penaltyt?, Can I convert the after-tax portion directly to a Roth IRA?…etc.,) and what might be a pragmatic approach that may be relevant.



Submitted by Alan Spross on Sat, 2009-02-07 22:38

There is never double taxation if the transactions are reported correctly.

Unless you reach a designated age in the plan, you cannot convert or rollover your 401k to an IRA until you separate from service from that employer.

Once you HAVE separated from that employer you can either:
1) Do a direct rollover to a traditional IRA. If you elect to roll the after tax funds into the IRA as well as the pre tax, you should file Form 8606 to report the after tax contribution amount contributed to your IRA. Subsequent to the IRA rollover, you could then convert to a Roth IRA and the portion of your total converted IRA balance that reflects the after tax amount on Form 8606 would be tax free.
OR
2) Eliminate the traditional IRA and convert your 401k directly to a Roth IRA. In this situation, only the pre tax amount of your 401k would be shown as taxable income on the 1099R in Box 2a.

You could also first transfer the pre tax amount to a traditional IRA tax free, and then convert the remaining after tax amount left in the 401k to a Roth IRA, also tax free. This is more tax efficient than rolling the after tax amount to your traditional IRA and then converting it.

For either of these conversions, there is an income limit of 100,000 for 2009. After 2009, the income limit no longer applies.

NOTE: The above comments assume your 401k is not already a Roth 401k. If it is, your options are totally different.

Submitted by charles lore on Sun, 2009-02-08 23:38

After much inquiry on the subject on withdrawals from retirement plans it is not clear that you can take all pre tax funds out leaving only after tax left in the plan and thus positioning yourself to do a tax free Roth conversion.
Withdrawals from plans may indeed have to come out pro-rata. Consider a withdrawal from a Roth 401k. A withdrawal comes out pro rata unlike a Roth IRA with has ordering rules. Why does Roth 401k come out pro-rata? .. well it’s it’s a Retirement plan and again plans come out Pro-rata.

This having been said I believe that you can request a distribution of ONLY the after tax money and it’s associated earnings. In other words you can do pro-rata with respect to only after tax funds. Example.

100,000 401k
80,000 after tax contributions
5,000 earnings ASSOCIATED WITH AFTER TAX FUNDS
15,000 pre tax.

You can get a distribution of 85,000( 80,000+5,000_This would be a pro-rata but ONLY WITHIN THE TAXABLE PART OF PLAN..

The would need to account for pre tax and after tax for thisi to be allowed.

Then convert the 85m to a Roth paying tax on only 5,000. Then roll the 15,000 to a TIRA.

At the end of the day this will all be driven by what your paln allows.

Submitted by Denise Appleby on Thu, 2009-02-12 23:00

[quote=”[email protected]“]After much inquiry on the subject on withdrawals from retirement plans it is not clear that you can take all pre tax funds out leaving only after tax left in the plan and thus positioning yourself to do a tax free Roth conversion.
Withdrawals from plans may indeed have to come out pro-rata. Consider a withdrawal from a Roth 401k. A withdrawal comes out pro rata unlike a Roth IRA with has ordering rules. Why does Roth 401k come out pro-rata? .. well it’s it’s a Retirement plan and again plans come out Pro-rata.

This having been said I believe that you can request a distribution of ONLY the after tax money and it’s associated earnings. In other words you can do pro-rata with respect to only after tax funds. Example.

100,000 401k
80,000 after tax contributions
5,000 earnings ASSOCIATED WITH AFTER TAX FUNDS
15,000 pre tax.

You can get a distribution of 85,000( 80,000+5,000_This would be a pro-rata but ONLY WITHIN THE TAXABLE PART OF PLAN..

The would need to account for pre tax and after tax for thisi to be allowed.

Then convert the 85m to a Roth paying tax on only 5,000. Then roll the 15,000 to a TIRA.

At the end of the day this will all be driven by what your paln allows.[/quote]

Hey Chuck,
Take a look at IRC 402(c)(2). It may change your mind. Let me know if you agree.

I agree with Alan’s responses, with some minor modification to the third option.
Assuming we are talking about post-1986 balances… Giri’s third option would be to Instruct the payor to rollover (direct) the pre-tax amount to the traditional IRA. The the after-tax amount can then be rolled to the Roth IRA as a conversion. This would result in a tax-free conversion.

If the distribution from the 401(k) is less than 100% of the balance, it will include a pro-rata amount of pre-tax and post-tax. For instance, using Chuck’s numbers, if he withdraws $85,000, that $85,000 would include 80% after-tax and 20% pre-tax. The 20% could be directly rolled to the traditional IRA and the 80% converted to the Roth tax-free.
The key is to ensure that the pre-tax amount is rolled over first- as the rollover rules provide that any amount that is rolled over comes first from the pre-tax amount. Sending the pre-tax amount to the traditional IRA a direct rollover so that there is no w/h, and sending a check for the after-tax amount to the participant would accomplish this. The participant can then deposit the amount to the Roth IRA W/I 60-days.

Submitted by charles lore on Fri, 2009-02-13 03:48

Ok Denise you leave me with no choice other than to pull out the big guns on this one since you and Alan have me backed into a corner. Below is Natalies resonse to 402c question from an email posted with her consent…

After reading tell me if you stand by your position and why…

Date sent: September 12, 2008 at 8:55
Name: Charles Lore
Company:

Comments: Natalie…I looked for a good hour in your book and could not find an answer to this question…

If a particiapnt has 1,000,0000 in a QRP ( profit sh/ 401k) and 800,000 is pretax … 200,000 after..Can he roll into a traditional ira the 800m and CONVERT the 200m to Roth?

The root of the question is does the QRP have to afdhere to pro-rata rule on distributions as would an IRA ( the book didnt seem to anwer this)

Lets assume plan would allow the ONLY the pre tax to be rolled to regular ira and will keep the 200m in th eplan until 2010 when he can do Roth..

If paln al;lows this can he in 2010 convert aftert tax to Roth ?

Dear Charles,
There is a good reason why I ducked that question in the book. I can’t figure out the answer. The Code (section 402(c)) has a nutty provision regarding this point when money is rolled from a QRP to an IRA (see emphasis):

c) RULES APPLICABLE TO ROLLOVERS FROM EXEMPT TRUSTS

(1) EXCLUSION FROM INCOME

If–

(A) any portion of the balance to the credit of an employee in a
qualified trust is paid to the employee in an eligible rollover
distribution,

(B) the distributee transfers any portion of the property
received in such distribution to an eligible retirement plan,
and

(C) in the case of a distribution of property other than money,
the amount so transferred consists of the property distributed,

then such distribution (to the extent so transferred) shall not be
includible in gross income for the taxable year in which paid.
[ok so far so good, a distribution is nontaxable if rolled over]

(2) MAXIMUM AMOUNT WHICH MAY BE ROLLED OVER

In the case of any eligible rollover distribution, the maximum amount
transferred to which paragraph (1) applies shall not exceed the
portion of such distribution which is includible in gross income
(determined without regard to paragraph (1)). The preceding sentence
shall not apply to such distribution to the extent–

(A) such portion is transferred in a direct trustee-to-trustee
transfer to a qualified trust or to an annuity contract
described in section 403(b) and such trust or contract provides
for separate accounting for amounts so transferred (and earnings
thereon), including separately accounting for the portion of
such distribution which is includible in gross income and the
portion of such distribution which is not so includible, or

(B) such portion is transferred to an eligible retirement plan
described in clause (i) or (ii) of paragraph (Cool(B).
[ok, still so far so good, nontaxable amounts can be rolled to a QRP or 403(b) plan only via direct rollover; now we get to the tough part:]

In the case of a transfer described in subparagraph (A) or (B), the
amount transferred shall be treated as consisting first of the
portion of such distribution that is includible in gross income
(determined without regard to paragraph (1)).”

If you can figure out what the highlight provision in the preceding paragraph means please let me know. It seems to say when there is a direct rollover out of a qualified plan, the amount transferred is treated as consisting “first” of the portion that would have been taxable if the distribution were not rolled over. Well suppose your facts, a $1 million QRP of which $200,000 is after tax. Suppose a direct rollover of $800,000 to an IRA. If $800,000 were distributed to the participant and not rolled over, the “cream in the coffee rule” (proportionate rule) would apply, so 80% of the distribution ($640,000) would be considered pretax money and 20% ($160,000) aftertax. Now instead of being distributed it is rolled over directly to an IRA….so the $800,000 distribution is deemed to consist “first” of money that would be included in income if not rolled over, so it consists “first” of the $640,000 that would have been taxable if this had been a distribution not a rollover….and the rest is therefore deemed to consist of the nontaxable money? So what? That’s still proportionate….$640,000 deemed taxable and $160,000 nontaxable….just the same as if this special clause were not in the Code at all.
So what 402(c) MUST mean is that the distribution is deemed to come first out of the part of the account that would be taxable if the entire account were distributed. If that’s what it means, then you could roll the $800,000 pretax money, first, to a traditional IRA, tax-free, then convert the remaining $200,000 from the QRP to a Roth directly tax-free. And that’s what 402(c) MUST mean, since its literal meaning makes no sense at all. And I’m told some qualified plan providers will code any distribution the way the employee wants. But all of this is not QUITE the same as having direct support in the Code!
Let me know if the above makes sense.
Natalie

Natalie B. Choate, Esq.
Ataxplan Publications
c/o Nutter McClennen & Fish LLP
155 Seaport Boulevard WTCW

Submitted by Alan Spross on Fri, 2009-02-13 04:55

Chuck,
Natalie’s letter concludes that the pre tax amount comes out first, but is not fully comfortable with her reasoning without an IRS clarification of same. So her conclusion is somewhat tentative, but it does agree with Denise’s position.

For my part, I arrived at this conclusion after reading the following link from McKay Hochman, which I have posted before. You can see that 402(c) codified section 411(q) of the JCWAA of 2002.

http://www.mhco.com/Library/Articles/2004/ARoll_Portability_080504.html

The conclusion is taxpayer friendly with respect to avoiding the pro rata rules in rollovers and also is fully consistent with the rules for a partial distribution and rollover of a designated Roth account (Roth 401k) to a Roth IRA, ie any rollover is pre tax until the pre tax funds are exhausted.

We do agree that observation of this conclusion is fully dependent on the 1099R issued by the retirement plan. It could also be expected that not all of them are in agreement since the IRS has not made 402c as clear as they might have.

Submitted by Denise Appleby on Fri, 2009-02-13 11:10

[quote]However, if the participant does not directly roll over the entire vested account balance, the Job Creation and Worker Assistance Act of 2002 (JCWAA) Section 411(q) states that the amount rolled over is treated first as pre-tax dollars and only after all the pre-tax dollars are rolled over will any after-tax dollars be credited to the rollover. Using the above example, if the participant directly rolled over the $92,000 of pre-tax dollars, the $8,000 not rolled over would be classified as after tax funds. Thus, after the $92,000 is rolled over, the participant could actually distribute the entire $8,000 of after-tax basis without any basis recovery rules applying. [/quote] http://www.mhco.com

It seems that the JCWAA provision is what creates the difference of understanding. If my understanding explanation above correction, it says that if the $92,000 is distributed first as a direct rollover, it will include all of the pre-tax amount. However, from my understanding of JCWAA/402(c) , ‘the pre-tax amount being rolled over first’ is applied after the distribution occurs. In short:
—–The distribution must happen first. When the distribution happens, it includes a prorated amount of pre-tax and post tax.
—–After the distribution occurs, then you apply the rollover rules. Under the rollover rules, the amount rolled over comes first from the pre-tax amount. It does not matter if the rollover is direct or indirect.

So, where the explanation seems to have taken a turn that it should have not, is where it says “Thus, after the $92,000 is rolled over, the participant could actually distribute the entire $8,000 of after-tax basis without any basis recovery rules applying.” This is becsause the basis recovery rule will [u]always [/u]apply…xcept for pre-1987 amounts. If you want to shake the basis recovery rule, you can only do so after the amount have been distributed from the 401(k) and by not tolling over the after-tax amount to the TIRA.

Submitted by charles lore on Sun, 2009-02-15 00:40

Alan or Denise…

In looking at Alan’s linked article a few question come up

1) What if 50,000 is rolled over from the plan which again is 92,000 pretax and 8,000 after tax. What is the breakout of the character? Assume a direct rollover.

2) Now assume a 60 day indirect rollover. I would have assumed we’d all be in agreement that in an INdirect rollover it is pro-rata. However the article in the second paragraph in bold says that the indirect rollover MAY NOT include after tax funds. Well how could the rollover be pro-rata and not have taxable funds in the character.Impossible ..so what am I missing?

Submitted by Alan Spross on Sun, 2009-02-15 04:45

Chuck,
1) In this situation the 50,000 should all be pre tax and show in Box 2a of the 1099R as taxable, but who knows how the plan will actually complete it. If they leave it blank, the employee will have to determine where their after tax basis resides.

2) What concerns me most about the second paragraph is the reference to “or an IRA”. On an indirect rollover a QRP cannot accept after tax contributions. For them to pass to another QRP, it must be a direct transfer. But since after tax basis can be rolled into an IRA since 2001, I do not understand why it says “or an IRA”, and believe that part must be in error. In this situation it would appear that the plan, not knowing whether the distribution will be rolled over or not, should be using the pro rate rules for the 1099R, and therefore changing their tracking of the remaining basis still in the plan in accord with the 1099R.

Since this is an indirect rollover, the 20% withholding required further complicates the issue as it will be part of the distribution, and the employee will have to replace those funds to complete a rollover. Moreover, unless the plan determines how much of the distribution is after tax, they will not know how much to apply the 20% withholding to. At this point, I think we could all use some IRS guidance. The stakes are now higher because a direct Roth conversion, first available in 2008 can either be done by direct rollover or by indirect rollover. It is important to note that if the first direct rollover to a TIRA is deemed to include the pre tax dollars first, then it can be arranged to flush them all out of the QRP, leaving only after tax amounts. Then, when a second distribution is made, it does not matter since only after tax dollars are left in the plan and the pro rata rules are moot.

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