401k basis
for those who want to move after tax dollars from a 401k to a roth – whats the best way? If you have a 401k with or where you have made non-deductible contributions move that to a roth, In conversion from a 401k to a roth ihave to pay tax on the conversion on pretax dollars.whats the best way tax wise on conversions of 401k with after tax and pretax dollars . the old prorata ruleis no longer the best way is it?
Permalink Submitted by Alan Spross on Wed, 2011-05-25 18:56
No, but getting around the pro rating is not easy. Direct rollovers may or may not work, and as soon as the IRS issues guidance to the plans on their 1099R forms, direct rollovers will probably be pro rated to each IRA type. Up to now, employees have been getting away with direct rollovers where only the basis goes to the Roth IRA, but that is only because the IRS has not clarified the reporting. This could change at any time.
However, there is a risk free way to pull that off if the employee has the funds to replace mandatory withholding on the pre tax portion. The way this works is that the employee does NOT request a direct rollover, instead asks to have the check sent to the employee. The plan will withhold 20% of the pre tax portion, so the employee has to have the cash to replace that withholding until his tax refund comes through. Here is an example:
500k total plan balance of which 100k is after tax
1) Employee requests full distribution, receives 420k because 20% of the 400k pre tax amount was withheld
2) Employee first rolls 400k to his TIRA
3) Then employee rolls 100k to his Roth IRA, making up the 80k that was withheld.
This gets around the pro rate rules because Sec 402(c)2 states that IF the employee receives the funds, the amount rolled over are considered to come first from the pre tax dollars. Therefore the first 400 rolled is pre tax and that goes to the TIRA. That leaves 100k (including replacement funds) that are considered to be the basis from after tax contributions and this amount can be converted tax free to a Roth IRA.
This is called “isolation of basis” because it isolates the 100k to just one of the rollovers instead of pro rating to both. But obviously it takes liquidity to pull this off. Doing it late in the year means that the 80k is recovered sooner.