IRS Notice 2009-68
We were under the impression that someone with after-tax money in a qualified plan could convert that separately from their pre-tax money to a Roth IRA. That strategy was to roll the pre-tax money to an IRA, and take a distribution of the after-tax money and do a 60-day rollover to a Roth Conversion. Our impression was that this was a valid strategy until IRS Notice 2009-68. Was that correct?
Notice 2009-68 appears to make a new distinction that pre-tax and after-tax money must be pro-rated, similar to the IRA rule (but not combined with IRAs or other plans). There are issues with this notice that I’m not going into that have yet to be resolved.
– In your opinion, is this notice likely to stick?
– Do you anticipate some sort of clarification notice retroactive to 1/1/2010?
– When might we expect to see guidance like this?
– Are you aware of any work arounds to convert that after-tax qualified plan money to a Roth IRA tax-free? There is one, but it would require you to roll the plan money to the IRA, roll all the taxable IRA money back into a new plan, convert the after-tax IRA money to a Roth IRA, and leave the taxable money in the plan until at least 1/1/2011. Is there anything more straight forward than that?
Permalink Submitted by Alan Spross on Fri, 2010-03-05 22:44
By not clarifying this issue better, the IRS may be accumulating a bunch of 2009 tax returns that report these rollovers without pro rating. The longer this situation stays in limbo, the more likely those that acted back in 2009 will end up achieving their objective. But I have no way of knowing whether the IRS will just clarify better or reverse course and allow isolation of basis in these conversions. Plan administrators are not getting sufficient 1099R instructions either, and this issue is not covered in the 402f Notice also revised last fall.
Here is a link to a current and thorough analysis of various strategies and their pitfalls. One issue that is not covered there is when the plan provisions only authorize an in service distribution of limited types of plan assets, eg the after tax assets plus their earnings. In that case, as in pre 87 after tax contributions, even if pro rating applies, it should only apply to the assets that can be distributed, not to the other assets that must remain in the plan.
http://fairmark.com/rothira/09030801-401k-basis.htm
Permalink Submitted by Tim Jansen on Fri, 2010-03-12 16:28
How does this affect distributions of only the after-tax portions from qualified plans? We used to be able to do a rollover of the pre-tax balance to a participant’s IRA and take a tax-free distribution of only the client’s after-tax balance. Does IRS Notice 2009-68 bring this common practice into question as well?
Two large investment houses have communicated that they will allow/process a distribution consistent with the strategy outlined in #2 of the Fairmark article. They may or may not be aware of the notice. What happens in the following scenario:
We proceed with converting only the after-tax balance from the plan to a Roth IRA as outline in #2
After the 1099R is processed on 1/31/11 it becomes apparent that the convertion will be pro-rated instead of tax-free
Can we then recharacterize this conversion from the plan into a traditional IRA and maintain the proper amount of pro-rated basis for the client?
Permalink Submitted by Alan Spross on Fri, 2010-03-12 19:30
You bring up an excellent point here, that the isolation of basis problem exists whether you are converting to a Roth IRA or not. Prior to 2001, after tax distributions from QRPS could not be rolled to an IRA, and therefore it was assumed that the direct rollover had to be exclusively pre tax, and two 1099R forms were issued with the full pre tax amount shown as a direct rollover. This has continued to be a standard practice today, but the situation described under Strategy 2 would exist whether the after tax amount was rolled to a Roth IRA or not. Therefore, the pro rate rules pose a threat to this practice as well, but I have not seen any articles that emphasize the potential issues here. And there are probably more of these distributions being done than direct Roth conversion, and there might be a problem with them as well.
Any conversion from a QRP to a Roth IRA can be recharacterized back to a TIRA, in fact it must be recharacterized there because it cannot go back to the QRP. The challenge here might be that the IRS does not question your tax return until the recharacterization deadline has passed. You would then be stuck with some added basis in your TIRA that would eventually be reported on Form 8606. And the portion that went to the Roth IRA would include some pre tax dollars which would make the conversion partly taxable. The good news here is that no basis is lost, and the bad news is that the basis must trickle into the Roth with Form 8606 until the TIRA is completely converted. This takes years barring a total conversion within a shorter time period. RMDs could also come into the picture before the TIRA is totally converted, and the RMD cannot be converted and will be at least partially taxable.
Permalink Submitted by Tim Jansen on Mon, 2010-06-28 14:53
Is there any news on how the IRS is treating after-tax balances in 401k’s when converted or distributed subsequent to 2009-68?
What about in practice? Are you aware how any institutions are proceeding?
Permalink Submitted by JAMES MAGNO on Mon, 2010-06-28 18:57
I am looking at IRS Notice 2009-68 under special rules and options. Third paragraph reads:
“You may roll over to an employer plan all of a payment that includes after-tax contributions, but only through
a direct rollover (and only if the receiving plan separately accounts for after-tax contributions and is not a
governmental section 457(b) plan). You can do a 60-day rollover to an employer plan of part of a payment
that includes after-tax contributions, but only up to the amount of the payment that would be taxable if not
rolled over.”
What does this last sentence mean: “You can do a 60-day rollover to an employer plan of part of a payment
that includes after-tax contributions, but only up to the amount of the payment that would be taxable if not
rolled over.”
This is confusing. If you don’t roll it over only the pre tax dollars are taxable. But this seems to be contrary to the pro-rata rule. Let’s say we have a $10,000 distribution with $8000 pre tax dollars. This last sentence noted above seems to indicate that the max rollover is $8000. and it is unclear what that $8000 is comprised of. It seems to me that they are referring to a rollover to another employer plan and that employer plan does separately track after tax dollars.
Thoughts?
Signed confused Jim
Permalink Submitted by Alan Spross on Mon, 2010-06-28 19:31
Jim, yes this is somewhat confusing since QRP rollovers are treated differently than rollovers to IRAs.
Boiling it down it essentially says that after tax contributions from a QRP can be rolled over to another QRP that will accept them, but ONLY if done by a direct rollover.
However, if the funds are paid to the employee, the employee can only roll over the pre tax amounts to another QRP in an indirect rollover. So in your example, the max that could be rolled indirectly to a receiving QRP would be the 8,000 pre tax dollars. The other 2,000 could be kept as a tax free distribution, rolled to a TIRA as basis, or converted to a Roth IRA tax free.
The amounts that came out of the first QRP did follow the pro rate rules, but the rollover to another QRP effectively isolated the basis. This cannot be done if the amounts were both rolled to an IRA or Roth IRA.