Conversion of After-Tax 401K $ into a Roth IRA

[BachemFan]

I have read with great interest some postings on Fairmark.com regarding the feasibility of rolling over after-tax contributions to a 401k into a Roth IRA. Unfortunately, I have not been able to find much updated information on the issue. I would greatly appreciate any thoughts anyone might have on my situation.

I recently lost my job. I am 59 1/2 years of age. I had a very good final year, and with my severance and bonus should have total gross income in excess of $5000K for 2011.

I have $623K in my 401k with my ex-employer. Of that amount, $175k is from after tax contributions (and does not include gains from those contributions). Ideally, I would like to roll the $175K into a Roth IRA, and the balance into a traditional rollover IRA. Of course I would like to avoid any tax event.

As I read an article from Fairmark.com at

http://www.fairmark.com/rothira/09030801-401k-basis.htm

(originally dated March 2009, but updated in February 2011), it seems the best way to do this is to have an indirect rollover. That is, have the 401k administrator send me the money in the 401k. Then, within 60 days I first send the pre-tax amount to Vanguard for the traditional rollover IRA, and then after that has cleared, send the after-tax funds to a new Roth IRA.

(I understand the issue with the 20% withholding, but fortunately I have sufficient funds elsewhere to put the full $175k into the Roth.)

Does this process pass muster with the IRS and reflect most current tax law changes? Will my high income level prevent me from doing this during the current year? Is the somewhat convoluted method of an indirect rollover necessary?

A rollover expert at Vanguard told me that isolating the after-tax basis for conversion can be done, but that the IRS regulations are somewhat contradictory on this matter. It is possible the IRS could clarify (with negative impact) after I did such a transaction.

I very much appreciate any thoughts readers might have.

Best Regards

[xerty24]

Just to address a few of your points - income level no longer matters for conversions. I assume you have no other job plans that might include access to a 401k plan? If not, that leaves you trying strategy #3. I'll leave others to comment on that status of that, but I don't think there have been any relevant changes recently.

On a side note, It's too bad you lost your job before you tried to convert your after-tax 401k contributions - if you could have done an in-service withdrawal/conversion to a Roth IRA you could have isolated most of the after tax portion (together with its earnings) from the pretax part since if you're under 59.5 they aren't allowed to distribute your (pretax) elective deferrals at all.

[Alan S.]

There has been no further IRS clarification on the "isolation of basis issue", but in your case you don't need it. Taxpayers trying to do this by direct rollover need the clarification.

Kaye Thomas' Strategy 3 using the indirect rollover does not require IRS clarification as this is clearly allowed per Sec 402(c)2 of the tax code. Since the replacement of 20% withholding is the main hurdle and you have the money to cover that, this is the way to go. The mandatory withholding will be ~$89,600. Just be sure to do the rollovers in the correct order, since 402(c)2 indicates that when you roll over a distribution, your pre tax dollars are considered rolled over first.

The gray area involves direct rollovers because the taxpayer does not receive a direct rollover because the check is made out to the IRA custodian. The IRS apparently feels that 402(c)2 does not apply in this case and pro rating should occur over both IRA types. The Employee Benefits Council has been pleading with the IRS for some resolution since late 2009, but have not received a response.

But doing Strategy 3 is not dependent on the IRS or on the plan issuing the 1099R in any particular manner. Your 1099R would show the gross distribution in Box 1 and the taxable amount (~$448k) in Box 2a. It will also show the federal withholding. You would show "rollover" next to line 16b on your tax return with no taxable income on that line.

Just be sure to complete both rollovers before the 60 day period elapses. The 2011 8606 has not been released yet, but you probably will not need one since your Roth conversion DID NOT come from another IRA, but from an employer plan.

As for the $89,600 you might be able to recover that sooner by reducing your other withholding or quarterly estimates so you will not have to wait until next year for the refund.

Also, since your conversion will be tax free, you can tap it if you need to without waiting 5 years, since the 5 year holding period for conversions only applies to taxable amounts and your conversion would not have any taxable amount.

[BachemFan]

Thank you both very much for taking time to respond to my inquiry. I now have a much greater comfort level with the process, and will proceed as outlined after Labor Day.

Best Regards

[jvclark02]

[quote="BachemFan"] I recently lost my job. I am 59 1/2 years of age. I had a very good final year, and with my severance and bonus should have total gross income in excess of $5000K for 2011.

I would say five million in 2011 is a 'very good year'

Congratulations!

[BachemFan]

I recently lost my job. I am 59 1/2 years of age. I had a very good final year, and with my severance and bonus should have total gross income in excess of $5000K for 2011.

I would say five million in 2011 is a 'very good year'

Congratulations!

I wish it was $5,000,000! My mistake... it was $500,000.

Best Regards