After Tax Rollovers
Employee with a 401k balance is $715k. The amount able to do in an “in service” rollover is around $314K of which $138K is after tax cost basis. We know that the IRS has closed the loophole for converting after tax 401k distributions to roth IRAs and is now subject to pro rata rules, but here is my thought process:
Client has no deductible IRAs outside of the company savings plan (Only a Roth for $25k).
1.) We roll out the entire amount available – one direct rollover to an IRA for the deductible amount and a check made payable to the employee for the after tax amount to deposit in his personal accounts.
2.) Once money is received roll the pretax money back into the company plan and do a 60 day rollover contribution of the after tax amount and immediately convert it.
If this can be done, the client would have essentially converted $138k of qualified money without having any tax liability.
Permalink Submitted by Alan Spross on Wed, 2010-12-22 18:20
That would work providing the employer plan will accept an incoming IRA rollover particularly just after distributing those funds. Since your TIRA could be a rollover or conduit IRA, the company might be more amenable to accept the funds back. You should clear this plan with them before acting. And no need to get this done in 2010 since your proposed conversion would be tax free and therefore no need to push for a 2010 conversion with time running out.
The IRS has not followed up their Oct 2009 Notices that dealt with assignment of basis, and therefore plan administrators will issue their 1099R forms just as they always have. Therefore, client would not have much risk by simply doing a direct rollover to a TIRA, requesting a check for the after tax funds, and then rolling the after tax funds to a Roth IRA within 60 days. I think it is too late for the IRS to try to re do 2008 and 2009 such transactions and they also did not advise plan administrators to do the 2010 1099R differently either, ie forcing them to pro rate the basis. And even in the outside chance the IRS tried to impose retroactive pro rating, the downside is not severe. Client’s conversion would be partly taxable, and if he did not want to assume the tax hit, he could recharacterize it to a TIRA and then all of the basis would be in the TIRA and documented on an 8606.
You might try your original plan first and if it cannot be done, the more aggressive Plan B might be worth considering.
A third option that is risk free is the indirect rollover of the entire balance where he would have to replace about 35,200 from the 20% withholding to complete the indirect rollovers (TIRA must be done first, then the after tax amount to a ROth IRA). If the distribution is done before year end, he gets the withholding back about a week after he e files his 2010 return. Of course, he may well not have 35,000 in cash that he can spare for a couple months, but if he does there is no risk with this procedure since it is covered in Sec 402(c)2 of tax code and not affected by the Oct 09 IRS Notices.
Permalink Submitted by Bradley Bofford on Thu, 2010-12-23 21:29
Thank you very much for your reply.
Since there continues to be such uncertainty with this type of particular planning, we reached out to another industry expert for his opinion on the matter. The following is the response we receieved. We are curious to what your thoughts are and what you would do for the client:
[i]”We know that the only method that appears to comply with IRS rules is a lump sum distribution with 20% withholding based on the pre-tax amount of the distribution. Then, you can rollover the pre-tax money plus the 20% withholding amount back into the company plan and then convert the after-tax amount of the distribution to a Roth. If your client has ample after-tax funds to make the temporary loan to the IRS of the withholding amount, the technique should work. The IRS has not blessed it but it has not subjected the technique to pro-rata treatment like the rest of the techniques out there including the one proposed below by your colleague because of Notice 2009-68. In other words, the two check approach suggested by your colleague appears to violate Notice 2009-68″.[/i]
Permalink Submitted by Alan Spross on Fri, 2010-12-24 00:57
There is no reason to take an LSD subject to 20% withholding when employee will have to roll the balance including replacement withholding into an IRA before a current employer plan could accept an incoming rollover. Therefore, if the plan is willing to accept an IRA rollover, it would be much easier to just do a direct rollover to a rollover IRA of the distributable balance, and then transfer the pre tax balance back to the plan.
Also, note that if the employee has other IRAs, they would have to rollover the entire balance in excess of the basis back to the plan, so that would require that the plan accept other pre tax funds beyond those they just distributed.
The other issue here is that the indirect rollover of an LSD by the employee is not a strategy that the IRS should have a problem with based on the Oct, 09 Notices because the tax code clearly states that if the employee receives a distribution and roll over that distribution (ie indirect rollover), the first rollover is deemed to be applied to the pre tax amount. That leaves only the post tax amount left and the employee can convert that tax free to a Roth IRA. This is the 3rd option from my prior post, and Notice 2009-68 and 2009-75 do not affect this procedure.
The problematic procedure is doing tandem direct rollovers, one to each type of IRA OR doing a direct rollover to a TIRA, receiving cash for the difference and then rolling that cash to a Roth IRA. This approach carries some risk, but I can’t see the IRS requiring these rollovers to be re constituted when they have failed to issue guidance in support of their 09 rulings.