Plan does not allow transfer of after tax to Roth

Submitted by Mary K. Dean on Thu, 2015-12-31 18:39

We just called Hewitt about a rollover of the client’s 401(k) to his IRA. There was about $20,000 after tax. They said that their plan does not provide for after tax transfers to a Roth unless it is a Roth 401(k). This is not a Roth 401(k).

Is that correct? Can they ignore the law that was passed in 2014?

Thanks …. Mary Dean



Submitted by Alan - IRA critic on Thu, 2015-12-31 20:15

Has client separated from service?

Submitted by Mary K. Dean on Sun, 2016-01-03 06:32

Yes, he retired from Northrop.  Hewitt is their plan administrator.

Submitted by Alan - IRA critic on Sun, 2016-01-03 16:52

  • Notice 2014-54 allows the basis to be isolated, but it does not change plan provisions governing the character of the funds distributed. As a major benefits administration firm, Hewitt should be capable of interpreting the plan provisions of a major employer. That said, it is odd that such a plan would be behind the curve in this area, so I would first recommend contacting Hewitt again to elevate the issue to more senior staff. Find out if they consider the after tax contributions to be held in a separate sub account per Sec 72(d)(2) and if so whether the plan allows distributions from the sub account only.
  • The plan provisions might still allow only a direct rollover to a TIRA for the pre tax amount and issue a check to the client for the after tax amount, which used to be the case before direct Roth rollovers. If so, all the client has to do is roll the 20k amount to the Roth IRA. There will be two 1099R forms and for the distribution of the 20k, there would not be anything taxable in Box 2a.
  • Is there any highly appreciated company stock in the plan with a low enough cost basis to consider NUA?

Submitted by Mary K. Dean on Sun, 2016-01-03 22:16

If the plan provisions are still under the pre 2014 change in the law, you recommended that the client roll the 20K to the Roth IRA.  Before the law changed in 2014, rolling an after tax contribution to a Roth was a grey area.  Is that still the case?  If no longer a grey area, how do we notify Schwab that it is a rollover?  Do we just attach the check with a letter saying that it is a rollover.Many thanks …. Mary! 

Submitted by Alan - IRA critic on Sun, 2016-01-03 23:21

Notice 2014-54 did establish that a participant could roll over a distribution of the after tax money after the pre tax balance had been rolled over. Therefore, requesting a direct rollover of the pre tax balance will take care of the TIRA rollover, and a 60 day rollover of the after tax money could then be done, without any objections from the IRS. It should be sufficient to tell Schwab to process the contribution as a rollover contribution. Schwab will then report it as such on the 5498 issued in May of the following year.

Submitted by Mary K. Dean on Sun, 2016-01-03 23:28

Thanks as always.

Submitted by Mary K. Dean on Mon, 2016-01-04 19:07

Hi Alan,One more question and all will be resolved.  My client is retired from Norhtrop but under 59 1/2.  There are no pre 59 1/2 penalties on the after tax?  If there is, will the Roth rollover eliminate them?Thanks again …. Mary!  

Submitted by Alan - IRA critic on Mon, 2016-01-04 19:15

Any early withdrawal penalty only applies to taxable amounts, not to after tax amounts. Further, a rollover to a Roth IRA is also exempt from penalty, even for the taxable amounts if any. So even if the client receives a 1099R with a code 1 in box 7, it is meaningless in both of the above situations.

Submitted by Mary K. Dean on Tue, 2016-01-05 17:41

Thanks again.  That is what I thought but wanted to be certain. Mary

Submitted by Ben Meyer on Wed, 2016-01-06 16:05

  1. The underlying issue here seems to be that Hewitt, the recordkeeper for the 401(k) plan, refuses to make a distribution consisting solely of after-tax funds.  This can be explained by understanding that there are different types of distributions from many 401(k) plans.  The first type is the RMD, which contains a combination of pre-tax and after-tax funds contributed after 1986, allocated pro-rata as specified by IRC 72(e)(8)(B).  This is the rule that Natalie Choat calls the “cream in the coffee rule”.  
  2. However, when a distribution is made that is not an RMD, and is made following separation, many 401(k) plans follow a different rule.  Instead of using the “cream in the coffee” rule, they follow an order of depletion of the sub-accounts of the 401(k) plan.  Usually the order of depletion is the pre-tax sub-account first, until depleted, then the company match sub-account, and lastly the after-tax voluntary contribution account, with its earnings.  (Other types of sub-accounts may also exist, such as rollover or profit sharing.)  Application of the order of depletion rule may possibly depend on the age of the separated participant, i.e. under or over 59 1/2, 70 1/2, so it is important to determine whether it will apply. .   
  3. The full application of the “cream in the coffee rule” would only come into operation if a total lump sum distribution were taken.  Only in this case could a mixture be received of pre-tax and after-tax funds that can be allocated to a TIRA and Roth IRA under guidance of Notice 2014-54.  It is also possible that the pre-tax and company match sub-accounts may have been previously depleted or otherwise lacking, leaving only the after-tax sub-account with its earnings.  In this limited case Notice 2014-54 would likewise be applicable for a partial distribution from the after-tax account.  This most definitely the way that distributions are handled for several large employer plans at Hewitt AON.  You should also be aware of customer service people who may give incorrect answers, but will then make distributions as I described above, since their software will do this automatically.  But after a payment has been made a correction will be difficult or impossible.  You need to ask your questions extremely precisely, and don’t accept the first answer you receive as it may be incorrect. 
  4. When a 401(k) plan makes a distribution, they will send a form 1099-R showing the amount of the distribution (in box 1) and the taxable amount (in box 2a).  Box 5 should also show the amount of employee contributions included in the distribution, and should be box 1 minus box 2a.  Also, very significantly, box 2b “Taxable amount not determined” will not be checked.  The meaning is that the 401(k) plan recordkeeper has made a determination of the taxability of the distribution that is binding on the recipient.  This is unlike a distribution from a TIRA where the custodian checks box 2b and the recipient determines the taxable portion using form 8606.
  5. So therefore, the “depletion order” of a 401(k) plan trumps the “cream in the coffee rule”.  Not all 401(k) plans provide for an “order of depletion”, but I have heard of a few that do.  Since this is being done by Hewitt AON, who is one of the largest recordkeeper service bureaus for 401(k) plans, and for more than one client employer, I assume they must thave a good legal reason for following this approach.  But I haven’t found the specific legal basis that allows a 401(k) plan to specify an “order of depletion” for non-RMD distributions following separation.  If anyone does know the legal basis, your reply would definitely be welcome.

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