In Plan 401k Roth Conversion or In Service Withdrawal of After Tax Funds to Roth IRA

Submitted by Heidi Davis on Mon, 2016-02-08 12:52

RE: In Plan 401k After Tax Funds Roth Conversion compared to an
In Service Withdrawal of After Tax 401k Funds Rolled to an Existing Roth IRA

My client’s company just offered the option of converting the after tax portion of his 401k to an In Plan 401k Roth-allows only 1 conversion per year.
Client’s Company also allows In Service Withdrawals of the After Tax portion of the 401k to be Rolled over to a Roth IRA-also only once a year.
Client is 63 and plans to retire around 6/2018– 2 years or so.
Client also has a Roth IRA which has passed the 5 year wait period on the initial deposit.
Client’s current after tax 401k market value balance currently is less than his after tax contributions.
Client’s income too high for any direct Roth contribution.

Client is now considering converting after tax 401k balance to In Plan 401k Roth soon because the conversion with his employer is now very easy to complete.
My understanding is that each after tax 401k to In Plan 401k Roth Conversion has its own 5 year wait period.
So for 3/1/16, 3/1/17 and 3/1/18 of after tax 401k fund conversions-5 years wait is added to qualify for qualified no tax distribution on earnings portion.
• Since he’s over 59.5, is only one 5 year wait period needed for all funds to be qualified?
When client retires in 6/2018, client would plan to move 401k Roth to existing Roth IRA.

My thought is that with the annual In Service Withdrawal of After Tax 401k funds that are rolled to an existing Roth IRA, there may be greater flexibility for the client due to having no wait period.
• If he annually transfers funds using the In Service Withdrawal of after tax 401k funds to his Roth IRA option, then isn’t the 5 year wait not needed for any funds any more (including the earnings)?
• When he retires in 6/2018, has used the 401k Roth option, so he’s now transferring the 401k Roth funds to his Roth IRA, won’t he have a new 5 year wait period on the earnings portion of his balances?
• At retirement in 6/2018, though, if he uses the In Plan 401k Roth Conversion option and then transfers this to his Roth IRA, is it correct that he will not need to start a new 5 year wait on the annual conversion amounts because the Roth IRA has already completed that requirement?

Thanks so much for your help in getting accurate information to the client.
Sincerely, Heidi Davis

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Permalink Submitted by Alan - IRA critic on Mon, 2016-02-08 15:43

In his current situation, it does not make much difference where the AT account money goes, but I think the Roth IRA has a slight edge, since his Roth IRA is already fully qualified. That means that any funds rolled into his Roth IRA also become instantly fully qualified.
There are two 5 year waiting periods in Roth accounts, but the one that applies to each conversion (or IRR) no longer applies after age 59.5. But to reach qualified status which makes earnings tax free, the Roth IRA is already there, whereas Roth 401k earnings will not be qualified for 5 years after the year of the first Roth 401k contribution. Of course, since he retires in 2 years and then rolls the Roth 401k to his Roth IRA, effectively there is only a 2 year wait since the entire Roth 401k money will be qualified when it reaches the qualified Roth IRA.
While recharaterization of a non taxable conversion is very rare, it could still come into play in a market meltdown to preserve the lost basis where it can do more good. An IRR can never be recharacterized, but a qualified rollover contribution to the Roth IRA can be, and the basis then moves to a TIRA where it can be used to reduce taxes on later conversions. For example, if his AT account held 50k and after rolling to a Roth IRA the value of that rollover (conversion) dropped to 30k, a recharacterization would put the entire 50 of basis in his TIRA. If his TIRA was worth 200k, he could then roll 150k into the pre tax 401k, and then convert the remaining 50k tax free since he would have 50k of basis. While not a likely scenario, this does provide an option of some value.