AFter tax contributions in a 401(k)
Greetings everybody. I just got off a conference call with my client and a representative at their 401(k) custodian about rolling over his 401(k) to his IRA. Normally this is pretty straightforward of course, but this time they threw me a bit of a curve. Unbeknowest to him (he’s rather naive about these things), $85,000 out of $650,000 was in after tax contributions (not NUA). I thought great, that gives us $85k tax free to work with and we can put off taking substantial distributions from his IRA (he’ll be 70.5 in September so we’ll have to take an RMD). But then his 401(k) team through me a curve. They said that he could roll the $85k into a Roth IRA and roll the rest into the regular IRA. Now maybe I’m missing something here, but I don’t think that this is really an option.
My understanding is that we can either take the tax free distribution and use it or reinvest it or roll the whole thing over into the IRA, keep track of the basis, and, with each distribution figure out the taxable from the non-taxable, paying only capital gains taxes. Now, of course, that’s a lot of book keeping that neither of us really want to do and since he’s going to need about $80,000 per year, it seems logical to me to just keep the $85k in cash and use it up first, delaying taxes for as long as possible.
Still, if there’s an opportunity to put it into a Roth, we need to consider that as he would like to leave a goodly sum to his 35 year old step son and passing it on tax free would be a nice thing. I’ve looked through several sources, including on-line and PNC, etc. and haven’t found any citation that tells me that it is possible to drop this $85k into a Roth. If I’m missing something I would certainly appreciate someone giving me a source. The 401(k) custodian couldn’t tell me what she was basing her assertion on.
Thanks for your help.
Cheers.
Michael Terry
Permalink Submitted by Alan Spross on Tue, 2010-06-22 22:30
Michael,
Unfortuneately, this question has no solid answer due to confusing IRS rulings on the subject. The American Benefits Council and other organization have been pleading for the IRS to clarify the situation. The basic issue is pro rating of basis vrs isolation of basis. Plan administrators have also not been given clear instructions on how to issue 1099R forms reflecting such dual direct rollovers.
About the only agreement is that this CAN be done through a full distribution and indirect rollover, first of the pre tax funds to a TIRA and finally the after tax amounts to a Roth IRA. The pitfall of doing this is that the taxpayer must be able to replace the 20% withheld to complete the rollovers. That’s $113,000 in this case.
One option here is to wait awhile longer to see if the IRS rules favorably on isolating the basis. Strangely enough, this question also brings into issue the decades old practice of just cutting a check to the taxpayer for the after tax amount.
Another option might be to secure a commitment from the plan administrator that their 1099R will support the dual rollovers, and hope that the IRS does not change their instructions to custodians before next January. If pro ration was required, it would not be disastrous. What would happen is that a share of the after tax money would go into the TIRA requiring an 8606 to report basis in the IRA, and most of the conversion would be taxable, creating a current tax bill.
I think I would wait for a few more months to see if this is resolved.
Here is a link further explaining the issue and options to address it:
http://fairmark.com/rothira/09030801-401k-basis.htm
Permalink Submitted by Joseph Arsenault on Tue, 2010-06-22 22:42
I have seen other topics in this forum cover this area of concern.
The IRS has has issued Rev Rulings that say Direct Conversions coming out of qualified accounts to IRAs are taxable pro-rata, so there is no ability to cherry pick the basis for a Direct Conversion. There is separate tax code however that says distributions issued to a participant of a qualified account comes out of pre-tax money first. So you would think that you could take all of the pre-tax money first (which would be subject to the 20% withholding) and then roll that over in 60 days (making up the 20% on your own). All you have left at this point is after-tax money, which you may be able to then directly convert without any tax.
To my knowledge the IRS has still not given clarification on this issue, and I know the American Benefit Council has pressed the issue and lobbied for more favorable treatment on direct conversions.
If my knowledge is out-dated, hopefully someone here can give us an update here. I have not yet seen any new information on this issue yet but am keeping my ears open. This would seem to be your only option to possibly separate the basis for the client.
Your right to question the custodian and feel tentative about their advice. The fiduciary obligation lies on the taxpayer to properly report any taxable rollovers or conversions.
One thing to correct, once you rollover the money to an IRA, even when keeping basis and all that, you do not receive capital treatment on the taxable portion. This portion is ordinary income.
Permalink Submitted by Joseph Arsenault on Tue, 2010-06-22 22:43
Alan, I think we replied at the same time. 😀
Thanks for providing a link btw.
Permalink Submitted by Alan Spross on Tue, 2010-06-22 22:53
Yes Joe, but our responses were very concurrent!
While no help for the current year, I suspect that since the “unwinding” of tandem distributions for 2008 and 2009 would be so ugly, those that reported for those years in concurrence with the 1099R that was issued are probably home free. If I were the IRS, I would strive to resolve this in time for the 1099R Instructions for 2010 to incorporate a resolution to the problem.