After tax 401k to Roth strategy

[jdilla1107]

Both my wife and I have Roth and Traditional Iras. I max my traditional 401k each year. My new employer also offers after-tax 401k contributions with in-service rollovers.

My understanding is that the pro-rata rule would apply to after-tax 401k to roth rollovers and since I have a TIRA, this would be bad.

I am thinking of:

- rolling my $150k TIRA into my employers 401k. (has good investments)
- continue doing 17.5k in 401k contributions.
- My employer matches 10,500 per year
- Adding another $28,000 in after tax contributions.
- rolling the after tax contributions into a Roth each year.

1) Does this seem all good? I'll be able to get a $28,000 roth each year? (I could also do another 5,500 directly to a roth IRA)
2) Does my wife's TIRA affect the pro-rata rule?

Thanks.

[dan23]

1) Yes, this will work provided you currently have no basis in your IRA. However your numbers are somewhat off. If you are under 50, the limit is 51k total (so 17.5 pretax 401k, 23k 401k after tax contributions, 10.5k employer). If over 50, you can do 23k in 401k pretax contributions and 23k in 401k after tax contributions, 10.5k employer. Yes, you could in addition do 5500 (6500 if over 50) either directly (if your income is low enough, which I doubt) or through backdoor to a Roth IRA.

Also, when you do your in-service withdrawal, the simplest and safest method will be to go direct to your Roth IRA and pay tax on any earnings in the after tax sub account of your 401k (if there are earnings). You should have your 401k send you a check of the nature "Vanguard FBO you" for the entire subaccount.

2) No it does not.

[Alan S.]

You don't need to roll your pre tax TIRA amounts into the 401k. These TIRA amounts do NOT affect taxation of your rollover of the after tax sub account amounts to your Roth IRA because you are NOT involving your TIRA in these Roth rollovers. The funds are going direct from the after tax sub account to your Roth IRA. That's true whether you do an indirect rollover or a direct rollover, but a direct rollover is best because mandatory 20% withholding is avoided on the earnings portion of the sub account.

Now, if you are also doing back door Roth contributions, things are different. Since these are initially non deductible TIRA contributions, the large pre tax IRA values hurt you. If you plan to do back door Roth contributions, then you DO need to roll the pre tax amount of all your TIRA, SEP or SIMPLE IRA accounts into the 401k. And if you do that, you also need to verify that the after tax sub account is distributed first and not affected by the TIRA funds you rolled into the plan until the after tax account is drained.

[jdilla1107]

Alan,

Thank you for your response. When I search Bogleheads and the internet for this, there seems to be all sorts of disagreement on your first paragraph. Is this because people are mistaken or is there some complexity that confuses people?

Is the "update here wrong?" http://www.kiplinger.com/article/retire ... sions.html

UPDATE: Since this story was published, questions have been raised about the strategy it discusses . . . of moving only after-tax money from a 401(k) to a Roth IRA. Although it is not crystal clear, it appears that the IRS believes a rollover of a 401(k) to a Roth IRA would be treated the same as a rollover from a traditional IRA to a Roth -- that is, that the amount of the rollover that would be tax-free would be based on the ratio of after-tax and pre-tax money in the 401(k).

Why is there so much confusion on this?

[tfb]

When I search Bogleheads and the internet for this, there seems to be all sorts of disagreement on your first paragraph. Is this because people are mistaken or is there some complexity that confuses people?

It makes a difference whether the pretax subaccount is eligible for distribution. If you are not yet 59-1/2, the pretax subaccount is not eligible for an in-service distribution (unless you rolled pretax money into the plan before). There's nothing to prorate with. After you are already 59-1/2 and the plan allows distributing both the pretax and after-tax subaccounts, some plans would do it proportionately and some plans are OK with distributing just the after-tax subaccount. That's when the complexity and confusion begin. It's best if you do it before 59-1/2 and not roll pretax money into the plan.

[Alan S.]

It's the update that is incorrect, the original article is fine. The update fails to recognize that after tax sub accounts can be treated as a separate contract. Here is Tax code Sec 72(d)(2):

72(d)(2) Treatment of employee contributions under defined
contribution plans
For purposes of this section, employee contributions (and any
income allocable thereto) under a defined contribution plan may
be treated as a separate contract.

To be considered a "separate account", the plan must maintain separate accounting for the employee contributions (pre tax deferrals and co matching are both technically employER contributions). With such separate accounting, distributions from the separate account are NOT pro rated with the other plan balance.

There also exists a "grandfathered" plan balance for pre 1987 after tax contributions in the plan. If separately tracked, the balance of pre 87 after tax contributions can be distributed by itself, separate from even the earnings on those contributions.

[jdilla1107]

I decided to have a CPA do my taxes this year as I have an incredibly complex K1 from a partnership. (It has 11 pages of hand typed addendums.) This CPA does taxes for Corporations. He had never even heard of an after tax 401k contribution, let alone this strategy. Is it possible that CPAs are just used to getting 1099s and not paying attention to how they are generated?

Anyway, do people here actually use this 401k after tax to Roth strategy? Is there IRS text that details it? Will Turbo Tax understand this?

[Alan S.]

Many CPAs and other tax preparers are not fully up to date on the options under the expanded retirement plan menu and portability between plans. All they see is the 1099R. If a plan does a direct rollover to a Roth IRA, the 1099R is very easy to understand and enter into professional tax software. The taxable amount (earnings in the after tax account) should show in Box 2a.

Now if you take a distribution and do your own indirect 60 day rollovers, complexity spikes. The preparer needs to know the amounts you:
1) Retained yourself
2) Rolled to a TIRA or other plan
3) Rolled to a Roth IRA
4) Used for NUA per Box 6
5) When you completed the rollovers and even in what order

Knowing how to treat these rollovers requires some knowledge of the tax codes as the 1099R issuer does not know what you did with the distribution, and this is where many professional are going to get tripped up.

[jdilla1107]

I came across this very detailed article which makes this seem contentious still.

http://www.kitces.com/blog/archives/360 ... rsion.html

As more and more baby boomers retire, an increasingly popular strategy is to split pre- and after-tax funds in a 401(k) at retirement, with the goal of rolling over the pre-tax funds into an IRA, and converting the after-tax funds into a Roth IRA, taking advantage of the non-taxable nature of the after-tax contributions. Yet the effectiveness of the strategy is ambiguous at best; recent guidance from IRS Notice 2009-68 would suggest that the approach shouldn't be allowed at all, and although some esoteric and technical workarounds have been suggested, none have truly been tested or subjected to IRS scrutiny. As a result, while many 401(k) plans are willing to issue separate checks to accommodate those who wish to try the strategy, and the odds of getting caught are low, caution is still merited about whether the client will really end out with the desired tax treatment.

[Alan S.]

Using direct rollovers does carry some risks, but the Fairmark strategy 3 does not. Of course, this strategy requires a distribution to the employee rather than direct rollovers, and therefore the taxpayer needs to have cash to replace the mandatory 20% withholding on the pre tax portion of the distribution. There should be no risks with Strategy 3, just some inconvenience.

As to the direct rollovers, the IRS has now had 3 years to address the inconsistencies and has no done so. There is no way that the IRS is going back to 2009 to undo all the direct rollovers that have been done, but there is some risk that 2013 direct rollover activity could be affected by revised 1099R guidance to plan issuers before the 2013 1099R season programming begins. Therefore, if you still want to test the waters with direct rollovers this year, you might want to wait until late November when it will be too late for the IRS to alter the 1099R instructions for issuers.

As for IRS scrutiny, there has been plenty within the IRS because the influential American Benefits Council has forwarded multiple letters to the IRS begging for a resolution. The first of those letters was in late 2009, just after Notice 2009-68 was released. For some reason known only to the IRS, there has been no response forthcoming.