Roth conversion of after tax & pre-tax 401k

Submitted by Joel Barretto on Tue, 2009-03-31 21:21

I have a client with about $750,000 in his 401(k) where about $250,000 is after tax dollars and the rest is pre-tax $. He recently retired and would like to convert the after tax $ to a Roth and put the pre-tax $ to a rollover IRA. How would the pro-rata rule apply here? Can we split the rollover and how would that affect him taxwise?



Submitted by Alan Spross on Wed, 2009-04-01 00:38

This question has been heavily debated this year, and the IRS really needs to specifically rule on it. The issue is Section 402(c)(2) and interpreting how it applies to direct rollovers as well as indirect rollovers. The safe way to accomplish the goal of the post tax balance going to the Roth is to do an indirect rollover, and after which the taxpayer rolls over the pre tax balance to the TIRA. If the taxpayer rolls over a distribution, the pre tax balance is deemed the first dollars rolled over. However, the problem here is the mandatory 20% withholding which the taxpayer would have to replace to complete the rollover. With 500,000 pre tax, this is 100,000 the taxpayer would have to access to replace the withholding. After rolling over the 500,000 to a TIRA, then the final 250,000 could go to the Roth IRA. Remember that modified AGI limits for conversions still apply in 2009.

The more debated method would be to do a tandem rollover, hoping that the pre tax ordering stated above would trump the pro rata distribution rules that would make each distribution 66.7% pre tax and 33.3% post tax. 402(c)2 is not very clear on whether this would fly, but if it did, client would just first order a direct rollover of 500,000 to a TIRA, then the same for 250,000 to the Roth. If the plan refused to do two direct rollovers, then the second one could be done indirectly through him. Despite the unstated IRS position on this, who knows how the plan will issue the 1099R forms? Right now, I am not very confident this second more convenient method would work.

Here is another issue. If the client has pre 1987 after tax contributions that the plan properly accounts for, these balances are NOT subject to pro rate distribution. So the client could request a direct rollover of only this balance to a Roth IRA. It is only the post 86 after tax balance that must be distributed pro rata with pre tax amounts in the plan.

Client could also wait until the IRS clarifies this in the event he does not have 100,000 handy to replace the mandatory withholding to carry out the safer plan described in the first paragraph above.



Submitted by Joel Barretto on Wed, 2009-04-01 01:24

Thanks Alan! I was at Ed Slott’s 2 day training last week and I looked it up on his manual on page 91. Here he states “there is NO mention of the pro-rata rule here. If the plan participant has after tax funds in his plan, those after tax funds can be converted to a Roth IRA from the plan with no income tax due on any of the after tax amount.” Another article from Kiplinger states “the tax law is clear: although you can roll the after-tax assets from you qualified retirement plan into an IRA, you can’t convert your after-tax contributiions to a Roth IRA without converting and paying taxes on a pro rata portion of your tax-deferred assets as well.” So now I’m confused ❓ I guess the best we could do is execute a plan until a ruling comes out and correct it at that point if necessary, would you agree?



Submitted by Alan Spross on Wed, 2009-04-01 02:19

Well, I think you could draft a plan for doing this, but hold off on executing it pending a ruling, unless he has the pre 87 after tax balance, or the 100,000 to put up to replace the withholding using the indirect rollover method.

The p 91 portion you quoted is not real clear to me. Obviously, there would be no tax due on the post tax amounts, but the main question here is whether any of the post tax amounts end up in the TIRA, while some of the pre tax amounts end up in the Roth. This is not what we would want.

There are enough opinions on both sides of the issue here to make me uneasy about the final outcome. But I do think the pressure must be building on the IRS to clarify the issue including the 1099R instructions to issuers. Up to this point, the only IRS advice on direct Roth conversions is in Notice 2008-30, and in that notice they do not even touch on this issue. Hopefully, you will have something before the year is out on this issue. The question has been posted her dozens of times already.



Submitted by Bruce Steiner on Wed, 2009-04-01 21:58

I’m not sure how common this issue is. Are there that many participants who have made substantial nondeductible contributions?

I haven’t researched this (since it’s your client, not mine), but Alan’s suggestion would be a good place to start. If that’s not practical, then perhaps you might want to apply for a private letter ruling.

Bruce Steiner, attorney
NYC
also admitted in NJ and FL



Submitted by Alan Spross on Wed, 2009-04-01 22:25

Here is tax attorney Kaye Thomas’ opionion on this issue:

http://fairmark.com/rothira/09030801-401k-basis.htm



Submitted by Denise Appleby on Wed, 2009-04-01 23:23

I am pretty sure I posted a reply, but for some reason it’s not here…luckily I typed it in Word… reposting…

I think the current rules do address this issue…
I agree with the Kiplinger statement. Since the regulations do not say otherwise, the current distribution rules should be applied. Bearing in mind that a Roth conversion is (technically) a distribution and a rollover-contribution, the following applies:
If the account has pre-87 after-tax amounts, those amounts can be withdrawn and converted to the Roth IRA.
For post-86 after tax amounts…if the individual is converting all of the withdrawn amount to the Roth IRA, then the amount will include a pro-rated amount of pre and post tax.
In your example, jnbarretto, the client would instruct the payer to issue two separate checks. The $500,000 as a direct rollover to his traditional IRA. The second check can either be issued to the Roth , or paid to him and he can rollover the amount to the Roth within 60-days. This would satisfy the requirements of IRC 402(c)(2), and JCWAA, which provided that the first portion of a distribution that is rolled over will include after-tax amounts.
I did not read the Kiplinger article, so I don’t know if they addressed all the possible scenarios. The quoted statement looks at an individual who is converted the entire withdrawn amount to a Roth IRA, and does not take into consideration the pre-87 rule. Maybe they looked at other scenarios?
When someone is distributing the entire account balance, it is cut-and dry. It gets complicated when a partial withdrawal is made, and this is where the confusion often occurs. The mistake that is usually made ( with partial withdrawals), is to ignore the pro-rate rule. For instance, in your client’s case, if he withdrawal only $250,000 , the $250,000 will include 1/3 after-tax and 2/3 pre-tax. Any amount rolled over from the $250,000 would come from the pre-tax amount first.



Submitted by Alan Spross on Thu, 2009-04-02 00:02

Hi, Denise.
If the goal is to get the all the pre tax to the TIRA and the post tax into the Roth IRA exclusively, it appears that you agree that doing back to back direct rollovers, first the pre tax to a TIRA and then the rest to a Roth IRA, will not work, barring pre 87 after tax contributions. That would agree with Kaye Thomas’ position.

My impression is that there are other experts out there that think this could work, and who knows what the 1099R forms will look like is someone orders two direct rollovers, or even the first one a direct rollover to the TIRA and the rest distributed to the employee.



Submitted by Denise Appleby on Thu, 2009-04-02 09:31

Hi Alan.
It appears that the IRS provides some guidance on how to report the transaction.
Issuing one check for the after tax amount to the participant and the check for the pre-tax amount as a direct rollover to the traditional IRA is one option. The 1099-R for the rollover to the TIRA would reflect a direct rollover and the 1099-R for the after-tax would show a regular nontaxable distribution. The participant would rollover to the after-tax amount to the Roth IRA within 60-days-resulting in the tax free conversion.
Under the second option, the participant can submit the request for the two checks and instruct the plan to pay one portion to the traditional IRA and the other to the Roth IRA. If you look at the last sentence in 402(c)(2), it provides some direction to the payer on how to treat the 1099-Rs. Using the example from the OP, if the participant request $500,000 to be paid to the traditional IRA and $250,000 to be paid to the Roth IRA, the payer would be required to issue a 1099-R for a direct rollover of $500,000 to a traditional IRA ( non-taxable, with Code G in box 7) and a 1099-R for $250,000- also nontaxable with Code G in Box 7 and with any basis recovery amount in Box 5. This too, would result in a non-taxable conversion.



Submitted by Joel Barretto on Thu, 2009-04-02 17:44

Wow, such great minds! So let’s say the client doesn’t qualify for a Roth conversion right now and we decide to wait until next year to roll that portion in the Roth. If we were to request a check for the $500,000 today (as Alan originally suggested)and roll it over to a TIRA within 60 days and add the 20% withheld amount to the TIRA. Would the 1099R consider a portion of that $500,000 as after tax $? Another question would be… let’s say there is $50,000 in pre-87 contributions which we request and roll into a Roth, how will the 1099R report that if we left the rest of the money in the 401(k) for now (assuming he qualifies to convert that into a Roth)?



Submitted by charles lore on Sat, 2009-04-04 15:34

If the retired client intends to work part time as a consultant or whatever he can open a solo 401k. He can then roll over the entire OLD 401k to his TIRA with no tax consequences if done as direct rollover. He can then roll over pre tax money from TIRA to NEW 401k which leaves only after tax basis in TIRA. He can then convert this tax free to a ROTH. This ” basis ectomy” is the way to accomplish this and be 100% consistent with clear and widely accepted IRS rules.



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