rollover of employer 401(k)
I am working with a client to roll over his ex-employer 401(k) to an IRA. We talked with Fidelity who is the administrator of the plan. The lady stated that he has before-tax and after-tax money in the plan. His choices are to do a full payout and rollover the entire balance or to rollover the before-tax and receive a check for the after-tax. But this is the part I don’t understand, she said he would not owe taxes on the after-tax distribution but would be subject to the pre 59 1/2 penalty. I did not think the after-tax would be taxed or penalized. Could this be particular to this plan? She also said that the after-tax amount is all contributions and no earnings.
Thanks for your help.
Permalink Submitted by Alan Spross on Thu, 2009-10-01 01:37
She is misinformed about the penalty. An early withdrawal penalty can only apply to taxable amounts. Since the after tax amounts are obviously tax free, there is nothing to penalize. Even if they show Code #1 in Box 7 of the 1099R reporting the after tax distribution, it is not a concern because the taxable amount on that 1099R will be -0-.
The only exception where a penalty can apply to non taxable (or already taxed) amounts is the 5 year holding requirement for Roth conversion distributions.
It is correct that earnings on after tax contributions are pre tax and typically are part of the pre tax portion that goes to a TIRA.
Client can still roll over the check for the after tax amount to a TIRA (or Roth IRA) if he wishes. He would then file an 8606 in the first year a distribution was taken from any of his TIRAs.
Permalink Submitted by [email protected] on Thu, 2009-10-01 17:51
It would seem the best strategy would be to roll it into a Roth IRA. Then he wouldn’t have to deal with the 8606. Does the plan make the check payable to the ROTH IRA or the participant and then he writes out a check to the ROTH IRA?
Thanks.
Permalink Submitted by Alan Spross on Thu, 2009-10-01 22:37
Either way should work. Remember, that this is still a Roth conversion so the 100,000 MAGI limit applies until the end of 2009, and if the check is made out to him, he has only 60 days to deposit it in the Roth IRA.
Permalink Submitted by Christopher Hess on Fri, 2009-10-02 18:35
Question on this. Wouldn’t the conversion of the after-tax money to the Roth IRA fall under the aggregation rules, and thus only a prorata portion of it be considered basis? I’m dealing with a similar situation and wondering if the following would work…Pretax money rolled into a conduit TIRA. After-tax money rolled into a TIRA. Then, move the conduit TIRA back to the 401k plan (to get rid of the aggregate problem). Then, in 2010 (due to income restrictions this year) convert the after-tax TIRA to a Roth. Thus, the new Roth IRA will have all after-tax money and the conversion will result in no tax due by the client. Does that make sense?
Permalink Submitted by Alan Spross on Fri, 2009-10-02 18:53
Yes, it makes sense, but after separation the 401k is not going to accept an IRA rollover. Even if employee had a current job with 401k plan, the plan may not accept IRA rollovers or may only accept rollovers from a conduit IRA. Even that would not help if taxpayer has other TIRAs that are not conduit IRAs.
The only sure way of isolating basis to the Roth and pre tax amounts to the TIRA, ie avoiding pro rate rules, is to do this by indirect rollover, where Sec 402(c)2 is clear regarding the sequence of participant rollovers. The taxpayer would need to have the funds to replace the 20% mandatory withholding on the taxable portion, could then to an indirect rollover of the pre tax amount to a TIRA and finally roll the after tax amount to a Roth IRA.
The problem with doing this same sequence using direct rollovers is the lack of IRA guidance. FIrst we had Notice 2008-30 that did not address this situation at all, then just a month ago the IRS released 2009-75 which did address basis, but still left some doubt when doing a lump sum distribution of the entire balance in sequence. By year end the total balance would be in TIRA and Roth IRAs, but it is not real clear whether ALL the basis would be in the Roth, or if some of it would end up in the TIRA and trigger an 8606 filing.
What bothers me is that before direct Roth conversions, there was no pro rating if employee directly rolled the pre tax balance to a TIRA and received a check for the basis. In fact, that was the usual procedure for years. So what is it that changes when the basis goes into a Roth instead of a taxable account? I think the main question here is whether 402(c)2 that establishes the order for indirect rollovers also applies to direct rollovers – or not. No telling what all these 1099R forms are going to look like come January. I think we need yet another IRS Notice to clarify this.
Of course, there is no possiblity of double taxation here, just a matter of getting the entire basis into the Roth immediately and without any pre tax dollars – without going through the indirect rollover and withholding scenario.
Permalink Submitted by Christopher Hess on Fri, 2009-10-02 19:18
That’s my frustration as well. It’s just not clear.
In my case, I am checking with the plan sponsor, Fidelity. They tell me the plan will accept rollovers back in. This is actually an in-service distribution so the 401k is still active. The great advantage to the client will be a nice sized Roth (which he otherwise is not eligible for due to income) and future ease of tax reporting since his after-tax and pre-tax money will no longer be commingled.
Client will need to keep all the tax documents (ie 1099-R, 5498, 8606) to establish the paper trail. It’s going to be a bit of work, but the long-term tax-free growth of the Roth will certainly make it worthwhile.
Thanks for your input.
Permalink Submitted by [email protected] on Wed, 2009-10-07 22:34
After reading all the comments, I am thinking that I will wait until next year to do his disrtibution. Then I can rollover the pre-tax amount, get a check for the after-tax amount, and put that right into the ROTH IRA because the income limits on conversions will be lifted.