Coffee-in-the-Cream Rule for 401(k)

Submitted by Jimmy Rench on Fri, 2014-07-18 21:54

I know it is basically impossible to separate after-tax and pre-tax money when you rollover a 401(k). Here is my question for you. What if your current employer allow you have a cup of coffee while you are employed? And what if it isn’t a cup of coffee, but a cup of cream with coffee added?

The scenario is that a client can do an in-service withdrawal from his 401(k) which is held at Fidelity. The catch is that only after-tax money is eligible to be rolled out. The other catch is that the earnings on the after-tax money has to be rolled out as well. So the client would roll $150k of after-tax money out of the 401(k) as well as $50k of earnings. He has no IRA accounts at this time. This would be his only account. What would stop him from doing a conversion? All the rest of his money, $400k, is still in the 401(k) and he plans to work a couple more years?

Someone might have covered this is another post. In that case, please accept my apologies for asking questions that have already been asked. Otherwise, is this a viable solution?



Submitted by Alan - IRA critic on Fri, 2014-07-18 22:51

  1. Yes. What you describe is a 401k plan that includes an after tax sub account under Sec 72(d)(2), that also permits in service distributions from such account. This setup is more typical of the 401k plans of larger employers. Since the sub account balance or any part of it can be distributed by itself, there is no pro rating other than between the contributions and earnings of the sub account itself. The rest of the 401k balance is NOT included in any pro rating. Of course, in your example there would be tax due on the 50k of earnings when this sub account is rolled into a Roth IRA.
  2. But the above scenario can itself be improved on by using an “isolation of basis” strategy which gets the 150k into a Roth IRA and the 50k of earnings into a rollover TIRA. No taxes are due. The safest way to do this is to ask for a distribution paid to the employee of the entire balance. The employee will receive a check for 190k because 20% of the pre tax amount of 50k goes to mandatory withholding. Within 60 days the employee rolls 50k into a TIRA and AFTER this is done rolls the remaining 150k into a Roth IRA while making up the 10k of withholding from other funds to make the rollovers complete. Per Sec 402(c)(2), when a distribution is paid to an employee and the employee rolls it over, the first dollars rolled over are deemed to be the pre tax dollars. This is why the TIRA rollover must be done first.
  3. There are other more risky ways to isolate, risky because the IRS could require pro rating to each IRA type. One of these methods is for the plan administrator to do tandem direct rollovers, 50k to TIRA and 150k to Roth IRA. The 1099R reflects this split. This method has also survived IRS scrutiny for nearly 5 years now since the IRS released Notice 2009-68. But this is more risky because Sec 402(c)(2) does not apply to it because the distribution was not made to the emplooyee and the IRS could change the 1099R Inst for plan administrators up to about November of each year. Therefore for someone that cannot afford to replace the 20% withholding and wants to use this riskier method, it would be best to wait until late November before doing tandem rollovers if the plan is willing to do them.

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