post tax contributions converted to a Roth in a defined contribution plan

Submitted by John Smith on Mon, 2017-04-24 21:41

Hello-

I have a defined contribution plan with my employer with what I assume is a not-so-common feature. After we have contributed the maximum allowed 401K contribution (Roth 401K or pre-tax 401K) to our plan, we are allowed to make after-tax contributions into our plan up to the IRS 415c limit. Further, we are then allowed to convert these post-tax contributions to a Roth “bucket” (for lack of a better term). This converted money is not a Roth IRA or a Roth 401K. It’s simply a separate “bucket” or category in our plan that shows up on our website when viewing the account simply as “Roth post-tax conversion.” (or similar, I forget the exact wording on the web page) When the conversion is made, taxes are owed on the earnings the post-tax contributions accumulated up to the conversion date.

Where would I find the IRS(?) rules governing this “special” type of Roth? I have tried googling, but of course all I am getting is rules concerning Roth 401Ks in defined contribution plans, which this category of money is not. I realize I could contact the administrator of the plan, but so few employees participate in this post-tax contribution and conversion that no one seems to know the government rules governing this special category of money.

Thanks.



Submitted by Alan - IRA critic on Mon, 2017-04-24 23:54

  • The ability to make after tax contributions is fairly common in the plans of large employers, particularly those with a high wage base.  The more recent trend now that most plans include a designated Roth option and more of those have added IRRs (in plan Roth rollovers), is to require the Roth rollover to be done as an IRR rather than a direct rollover out of the plan to a Roth IRA. Plans generally want to retain the assets if they can.
  • I have never seen any IRS guidance on the alternative you describe, so my guess is that this “bucket” is part of a designated Roth account as a result of an IRR, although presented to appear separate. Plan supporting platforms do not always keep pace with the tremendous rate of additional portability and options in the last 6 years or so.
  • Plans offering IRRs must incorporate additional accounting levels to separate the otherwise “distributable” amounts (ODAs) from the otherwise  “non distributable” amounts (ONAs), in the event that a participant requests a distribution. After tax contributions are generally distributable, and remain distributable even after the IRR. An IRR is similar to a Roth conversion in that a 5 year holding period applies to the pre tax portion of the IRR to avoid a 10% penalty if distributed before the 5 years is up or age 59.5 is reached. No doubt that all the additional accounting requirements such as this discourage some companies from adopting IRRs. Some plans provide IRRs ONLY for the ODAs, and not for the ONAs as a result.
  • You should contact the plan administrator for description of the plan options. If you have a choice to make to distribute to a Roth IRA, that option is generally best due to the Roth IRA more beneficial distribution rules. And if the plan definitely states that this account is not part of the designated Roth, would appreciate your posting back regarding the account setup.

Submitted by John Smith on Tue, 2017-04-25 18:32

I had another conversation with the administrator after reading your response- thanks for taking the time to type all that out.  This representative was a bit more knowledgeable and admitted that so few people take advantage of this IRR option that sometimes customer service may not be familiar with the details.   

  • Your bullet point one:  Yes, large company with highly compensated employees.  After-tax contributions can be done as an IRR or a direct rolloever out of the plan to a Roth IRA. 
  • Your bullet point two: Yes, the “bucket” I describe is a designated Roth account as a result of an IRR. 
  • Your bullet point three: Yes, the money is kept separate because the distribution rules are different. 
  • Your bullet point four: The plan separately categorizes employee pre-tax 401K contributions, employee Roth 401K contributions, the company’s contributions to our plan, employee after-tax contributions, and employee IRRs.

 Point taken about being better off just distributing to a Roth IRA.  I haven’t done that for a couple of reasons.  One, easier bookkeeping with the IRR and all of my other retirement money in one place, and two, I figure when I separate or retire from the company, I could simply just take the IRR account and roll it to a Roth IRA at that point.  My understanding is that by doing that, I could avoid the required minimum distribution (RMD) requirements if the IRR were otherwise to stay in the plan during retirement, and that the 5 year rule is also taken care of becasue I will have owned the IRR for more than 5 years prior to rollover. So it sounds like there really aren’t any specific “separate” rules concerning this IRR money as I originally asked and you answered.  You described the age and penalties associated with an IRR, and my administrator states that required minimum distributions are required.  It pretty much sounds like this IRR money is treated like a Roth 401K, even though it really isn’t a Roth 401K and is accounted for separately within the plan. Unless you have some aditional comments, I think you have answered my question.  I do appreciate your time.

Submitted by Alan - IRA critic on Tue, 2017-04-25 20:30

  • The IRR is part of the Roth 401k just as a Roth IRA conversion is part of your Roth IRA. The IRR functions the same as a Roth IRA conversion but with a couple differences. One large difference is that you cannot recharacterize an IRR like you can for a Roth conversion, but in your case your IRR will be heavily funded with after tax contributions and therefore there would be no reason to need recharacterization.
  • Once you eventually roll your Roth 401k (including Roth 401k deferrals, IRRs, and earnings) over to a Roth IRA, then Roth IRA accounting takes over. If your Roth 401k is qualified (5 years and 59.5) at the time of the rollover, the entire Roth 401k rollover is treated as a regular Roth IRA contribution (available tax and penalty free) even if your Roth IRA is not yet qualified. Once your Roth IRA becomes qualified (5 years and 59.5) as well, then all earnings generated in your Roth IRA will also be tax free.
  • If you roll the Roth 401k over before the year you reach 70.5, you will avoid any Roth 401k RMDs.
  • Some people who have creditor concerns and live in a state that provides poor IRA creditor protection (such as CA) will leave their money in the qualified plan. But that is about the only benefit compared to the Roth IRA.
  • Sounds like your plan is very broad with these options. The only other factor is whether the investments included have low ERs. But you do not even need to worry much about that with respect to the after tax contributions if you can roll them out to a Roth IRA shortly after contributing.
  • Re 401 RMDs – strangely enough, IRS rules allow your pre tax 401k and Roth 401k to be aggregated. In other words, you could take your combined RMD in any combination from these accounts IF THE PLAN also allows this. While this sounds good because you can actually avoid Roth 401k RMDs, the Roth 401k balance will result in larger RMDs from the pre tax account and that will increase taxes. So even if your plan allowed aggregation, you would still want to roll the Roth 401k to a Roth IRA before 70.

Submitted by John Smith on Wed, 2017-04-26 01:53

Great info Alan.  That is FAR more information than I have received about this type of plan than anywhere else.  I much appreciate your time.  I owe you a few adult beverages at whatever bar you and Ed Slott hang out at : )

Submitted by Ben Meyer on Fri, 2017-04-28 05:30

Alan, in your posting above you stated: “One large difference is that you cannot recharacterize an IRR like you can for a Roth conversion, …”.  But can a recharacterization be effectively performed by rolling over the designated Roth 401(k) to a Roth IRA, and then recharacterizing the Roth IRA to a Traditional IRA?  This assumes that the 401(k) plan permits the rollover, and that the rollover and recharacterization are performed by October 15 of the year following the year of the IRR.

Submitted by Alan - IRA critic on Fri, 2017-04-28 17:22

Benn, the Roth IRA custodian can only recharacterize a contribution made to the Roth IRA. Such contributions include qualified rollover contributions (pre tax employer plan to Roth IRA) and conversions (TIRA to Roth IRA).  A direct rollover from a pre tax 401k to a Roth IRA can be recharacterized per Notice 2008-30, but again this is a contribution made directly to the Roth IRA. An IRR on the other hand is not a Roth IRA contribution, but a Roth 401k contribution. It also follows that no portion of a tax free transfer from a Roth 401k to a Roth IRA could be recharacterized to a TIRA.

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