required distribution from 401(k)

Submitted by Michael Porfido on Tue, 2010-04-27 21:15

I am working with my client who is more than a 5% owner of his company and is 71 years old, so he has to take a required distribution. My question is, why not roll this into a ROTH IRA directly from the qualified plan? He doesn’t need the money and he has the money outside to pay the taxes. He is going to have to take a taxable distribution anyway, but if he puts this into the ROTH he won’t have to pay taxes anymore on this money. Is there any thing to be aware of by using this strategy?



Submitted by Alan Spross on Tue, 2010-04-27 21:32

Since the RMD requirement is a statutory RMD requirement, it cannot be rolled over to any other retirement account. Therefore an RMD is not considered an eligible rollover distribution, whether taxes are paid due to Roth conversion or not.

This is different that the case where a less than 5% owner is still required to take RMDs from the plan because the plan itself required it. There are not too many of those around, but in that event since the RMD would not be a statutory RMD, that one could be rolled over to an IRA or converted to a Roth IRA.

For this client, while he cannot avoid the RMD, he might be able to use the distribution to afford a higher contribution to the plan. A higher contribution would be tax deferred and possibly offset the tax bill for the RMD. In his case he can continue to contribute up to the max allowed, but must also take those annual RMDs.

Submitted by [email protected] on Tue, 2010-04-27 21:37

So his RMD cannot be rolled over. What about if he takes out an additional amount over and beyond his RMD. Can that amount be rolled into a ROTH IRA?

Submitted by Alan Spross on Wed, 2010-04-28 02:04

Yes. First the RMD must be distributed and after that is done, an additional amount can be converted to a Roth IRA assuming that the plan allows these extra distributions while he is still employed.

The first distribution year is the year he reached 70.5, but that was apparently in 2009 when RMDs were waived. So effectively his first RMD year is 2010 which means that only one RMD based on the 12/31/2009 account balance needs to be distributed before converting.

Submitted by Sharon Lund on Fri, 2014-09-05 20:27

Background: A 70.5+ year-old client who is more than a 5% owner of a company just added a Roth option to his company’s 401(k). He plans to keep working and to continue contributing for as long as he is able.  All previous contributions to his existing 401(k) have been made on a tax-deferred basis. His MAGI makes him ineligible to contribute directly to a Roth IRA.  Given: 1) The plan allows in-service withdrawals, 2) “Normal” RMDs are distributed “pro rata” from a 401(k) that offers both Roth and tax-deferred components, and 3) The client already has a Roth IRA that was 100% funded by a 2010 conversion that is about to hit the 5 year eligibility mark for tax-free withdrawal of earnings (whereas the separate 5-year clock within the 401(k) would just be starting). Please comment on the following potential strategy to maximize tax free growth; 1)Take 2014 RMD from existing 100% tax-deferred sources BEFORE making any new Roth 401(k) contributions (to avoid the “pro rata” rule), 2)Then, permanently change over to 100% Roth employee elective contributions, 3)Before 12/31 each year, initiate a 401(k) in-service tax-free withdrawal/rollover to his Roth IRA that he limits to 100% of the Roth source contributions and any earnings on those contributions, 4)BEFORE the 1st employee elective Roth contibution posts in January of each year via payroll deduction, initiate the annual RMD based on the 100% tax-deferred balance remaining in the 401(k) as of the prior year-end, 5) Repeat steps #3 and #4 each year. Theoretically, this “back door” route would allow him the equivalent of $23K in contributions to his Roth IRA each year that can grow tax-free over the course of his lifetime with RMDs delayed until another generation potentially inherits. Thoughts on this strategy?  Also, once the Roth IRA reaches the 5-year eligibility mark for tax-free withdrawals (i.e, 2015), is it safe to assume that any growth in the 401(k) attributable to Roth contributions before rolling 100% of his Roth 401(k) balance into his Roth IRA are eligible for tax-free withdrawals as well (i.e., this Roth 401(k) growth, now in the Roth IRA, assumes the 5 year clock of the Roth IRA, and not the just started clock of the Roth 401(k))?

Submitted by Alan - IRA critic on Fri, 2014-09-05 21:29

  1. Before commenting on the strategy, please define what the plan “pro rata rule” states. The IRS RMD requirements dictate that the RMD must be separately satisfied before any rollover of additional amounts can be done. Each part of the plan must separately satisfy the RMD, so if all distributions must be pro rated according to the same balance, the YE balance would have to be used for both purposes.
  2. It is clear that meeting the RMD rules and then rolling the entire Roth balance out late in the year to a Roth IRA will reduce or eliminate actual Roth 401k RMDs since there will be no balance or maybe just one salary deferral in the Roth 401k at year end.
  3. Yes, once the Roth IRA is qualified, any distributions regardless of source will be tax free.
  4. Can address the first part of the strategy once I understand what the pro rata rule adopted by the plan requires.

Submitted by Sharon Lund on Fri, 2014-09-05 22:22

To clarify what I mean by “pro rata,” I’ll try to give an example.  If someone has $100K in one 401(k) at the end of 2014, of which 20% is attributable to Roth contributions and growth, I believe the financial institution would be required to distribute 20% of the 2015 RMD from the Roth source and 80% of the RMD from the tax-deferred source of the 401(k).  Is that correct?  (Also, is it safe to assume that the financial institution would also be required to generate two 1099-R’s, one for each portion of the MRD from the same account?)  If these assumptions are correct and the total required 2015 RMD from the $100K 401(k) happened to be $5000, the financial institution would then be required to distribute $1000 from the Roth “source” and $4000 from the tax-deferred “source.” To further complicate matters, it appears that any growth — attributable to Roth contributions before the separate 5 year clock for a Roth 401(k) is reached — is also taxable?  So, if $300 of the $1000 Roth portion of the total $5K RMD was attributable to growth before the separate 5 year clock from the first Roth 401(k) contribution were reached, then $4.3K of the total RMD would be taxable to the investor?

Submitted by Alan - IRA critic on Fri, 2014-09-05 23:41

  1. OK-that is what I thought you meant and your example is correct. Each portion of the 401k plan must distribute an RMD calculated as if it was a stand alone plan. In your example the respective year end balance of the pre tax account would be 80k and the Roth would be 20k. The RMD for either portion cannot be satisfied by taking more out of the other portion. And there would be a 1099R for each RMD distribution because the distribution codes for Box 7 differ. And a 3rd 1099R for the Roth 401k rollover to the Roth IRA if a direct rollover is done because that requires the direct rollover code H. 
  2. Determination of the taxable portion of the Roth 401k RMD is a little more complex. If that RMD is taken out early in the year there would likely be very little in earnings included for years that the Roth 401k was drained by doing a prior year end rollover to a Roth IRA. But earnings are pro rated into the RMD distribution because the Roth IRA distribution ordering rules do not apply to a Roth 401k. So the Roth 401k RMD might include a small taxable amount from the earnings portion. Your second example is also correct, ie 4300 of taxable income from both RMDs combined.
  3. Now to revisit your original post, since client did not have a Roth 401k balance prior to this year, there is no Roth 401k RMD for 2014 even if he starts contributions this year. But if he elects to contribute to the Roth 401k this year, then he should plan to roll out the balance in December to reduce or eliminate a 2015 Roth 401k RMD. For Point 1 of your proposed strategy, this would not be necessary because the 2015 RMDs from each portion are solely based on the 12/31/2014 balance, there is no actual pro rate calculation since the two portions are viewed as separate for RMD purposes. So client can contribute to whatever portion he thinks is best (current tax bracket vs estimated brackets after retirement). Whichever portion gets his contributions for the rest of this year will just have a larger balance at year end and a larger RMD for 2015. But as stated in the first line here if he goes with Roth contributions, then he needs to do the year end rollover out of the Roth 401k to reduce the 2015 RMD from the Roth portion. And if Roth contributions are made, the pre tax account will also grow less and that will reduce the taxable RMD for 2015 from the pre tax account. But client would pay taxes on his 2014 Roth contributions as they are post tax, and that will shift income to 2014 and reduce it for 2015.
  4. The RMD implications are clear, but a detailed analysis is needed to determine if for the longer term he would be better served by pre tax contributions or Roth contributions. Contributions made in any year will increase the following year RMDs, but only if the balance is not rolled out of the plan after taking the current year RMDs. Client could roll out the pre tax portion to a TIRA if he wanted to as well, but since he already has a pre tax balance he must take his 2014 RMD first.
  5. I wondered about your pro rata statement because some plans (such as the TSP) have a requirement that non RMD distributions must come out pro rated between the portions. If his plan had that requirement, if he rolled out the Roth portion before year end, he would also have to roll out the pre tax portion. I think that requirement is rare in private 401k plans, but if his plan has that requirement they will let him know when he goes to roll out the Roth portion.  

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