401k After Tax account to Roth
Hi,
My client (age 58, already retired) has about $22k in the “After Tax” part of the 401k and about $18k in basis.
Balance in the 401k is about $300,000.
He has no Roth’s yet, so trying to start one with a “low tax cost”.
His company will not split the growth and basis part of the account unless it is pre-1986 contribution (it’s not).
Two years ago, he moved about $300,000 of the 401k to an IRA, and Form 5498 (IRA Contribution Information)
indicates taxes are still due on the growth part 90%.
Can my client just rollover the $22k “After Tax Account” directly to Roth IRA (before 2012 year end)
and pay taxes only on the growth part (18%)?
Not excited about getting a check to him at home. But if necessary…..
Or does this not qualify as an exception to 72, and he must pay taxes on 90% + of the rollover?
Can the before tax 401k be rolled directly to an IRA same time, next day –then this becomes 2 distributions, so no exception to 72?
What if wait until 2013 to roll 401k to IRA?
Working to help client increase Roth balances in efficient way.
Not sure, if should roll the 401k to an IRA yet because will increase proportional % to be taxed.
Your thoughts? Thanks so much for your time. Heidi
Permalink Submitted by Alan Spross on Mon, 2012-11-26 17:31
Since client has separated from service, any distribution from the plan will have to be pro rated between the pre tax and post tax amounts. Client may have been able to take a separate distribution of the 22k before retirement, but that is no longer possible. Therefore, the 22k cannot be separated from the 278k pre tax balance. That leaves these methods to attempt to isolate the basis to a Roth IRA:
1) Method supported by tax code is an indirect rollover to client and two rollovers by client, but client would have to replace the 20% withholding to complete the rollovers. That’s about $56,000. He would recover the 56,000 when he files his return.
2) Client could have a direct rollover of the pre tax amount done to a TIRA account and request a check for the 18k. He would then roll the 18k to a Roth IRA. While this will probably work because it has been working since the IRS released Notice 2009-68 and taxpayers have been doing this since that time, there is some risk that the IRS would require pro rating, but it is relatively a small risk at this time. If the IRS did disallow his 1040 reporting, he would end up with a mostly taxable Roth conversion of 18k, and the rest of the post tax amount would be in his TIRA, resulting in 8606 basis in his TIRA. He might be able to recharacterize the conversion or it could be too late by the time the IRS notifies him. The chance of disallowance is probably less than 10%, as the IRS has been allowing this isolation of basis to skate through for 3 years now.
If client wants to proceed, his risks are lower by completing the rollovers this year. Waiting until 2013 provides the IRS another year to issue revised 1099R instructions to plan issuers.
Permalink Submitted by Heidi Davis on Tue, 2012-11-27 06:20
Hi Alan,
Thanks so much for your time and your thoughts!
To confirm my understanding and logistics-
1. client does direct rollover of pre tax amount 18k to TIRA-
clients companys plan 401k Plan says will not split growth and basis in the After Tax account except pre 1986 funds-this is not pre 1986
If they won’t send out after tax basis only-can we tell them to review IRS Notice 2009-68?
2. why are the 2 extra steps required of TIRA, then requesting the check, then roll to Roth?
Thanks for your ideas to help out this couple. Heidi Davis
Permalink Submitted by Alan Spross on Tue, 2012-11-27 16:56
1) Are you sure the company refuses to send a check for the after tax amount only? That requirement that the 4k of earnings must go with it typically ends after the employee has separated from service. Is the plan willing to do a direct rollover of the rest of the balance, but send a check for 22k to the client?
2) The two step process derives from Sec 402(c)2 which indicates that if the employee receives a distribution from the plan (not a direct rollover), the first dollars rolled over are the taxable amounts of the distribution. Therefore, to achieve the goal of the taxable amounts going to the TIRA, the TIRA portion must be completed first. What is left is the after tax amount and that can be rolled to the Roth IRA.
The client could still perform step 2 if the company insisted on sending a check for 22k less 20% mandatory withholding on the pre tax amount (20% of 4,000 = $800). Net check would be 21,200. Client could then roll 4,000 to his TIRA and when that is done roll 18,000 into the Roth making up the $800 that was withheld to complete the rollovers. Nothing would be taxable and client would get a tax refund for the withholding when he files (or it would be credited to other tax due). The rest of the 401k would be rolled to the TIRA as a direct rollover. There is a small amount of risk doing this, but the client probably does not have the cash to replace 56,000 which would be necessary if he received the entire plan balance with that large amount withheld.
Permalink Submitted by Heidi Davis on Wed, 2012-11-28 08:32
Alan,
Thanks again for your brainpower!
No, I’m not sure about the company refusing to send the check of just the basis of the after tax part.
I hadn’t read anything about the separated from service– so really appreciate that!
I think now I’m leaning on the “conservative side” on this strategy due to the possible audit and IRS “intent”.
Thanks for the info on the possible risk-very helpful.
I’ll pass this on to my client, and let them make their own decision on it.
I can see that right now, with this strategy being “in the grey period” on this “no cost Roth” vs “pro-rata”,
you could lean either way for “do it” or “don’t do it”.
Also, I hope you know what an incredible service you do to help us “educate stressed out clients”.
You know so much on IRA’s, it blows my mind!
Ed Slott should be paying you a lot for helping all of us out!!!
Thanks again, Heidi