Forgot to do in-service withdrawal/conversion of mega backdoor

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johnanglemen
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Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

A friend of mine works at a company that allows maximum 401k aftertax contributions, as well as in-service withdrawal to a Roth IRA or rollover to Roth 401k. They have been maxing out their 401k over the last few years (i.e. up to the ~$56k limit).

But... they forgot to do step 2. So now they have about $17k of *earnings* accumulated in the aftertax subaccount.

Should they just bite the bullet now and convert those to Roth? What are the considerations that go into that?

Also, can they at least start converting their *new* aftertax contributions to Roth? I assume that's done on a pro-rata basis and therefore it's all folded into the same decision here?

Thank you.
sailaway
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by sailaway »

It depends on their tax bracket, years to retirement, expected income in retirement, whether or not they want to do backdoor Roth....

The third option is contributions to Roth IRA, earnings to tIRA.
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johnanglemen
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

sailaway wrote: Sun Jan 10, 2021 8:36 pm It depends on their tax bracket, years to retirement, expected income in retirement, whether or not they want to do backdoor Roth....

The third option is contributions to Roth IRA, earnings to tIRA.
Can you share how backdoor Roth factors in? They actually have been doing that every year. Does that only come into play if/once they send the earnings to tIRA and contributions to Roth (because then there's a pro rata problem)?
dlrkw9mu
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by dlrkw9mu »

johnanglemen wrote: Sun Jan 10, 2021 8:38 pm
sailaway wrote: Sun Jan 10, 2021 8:36 pm It depends on their tax bracket, years to retirement, expected income in retirement, whether or not they want to do backdoor Roth....

The third option is contributions to Roth IRA, earnings to tIRA.
Can you share how backdoor Roth factors in? They actually have been doing that every year. Does that only come into play if/once they send the earnings to tIRA and contributions to Roth (because then there's a pro rata problem)?
not the original commenter- but right. Some plans will allow in-service roll-over contributions, though. Meaning they may be able to roll after-tax contributions to a Roth IRA, after-tax earnings to a traditional IRA, and then roll the traditional IRA funds back into the traditional 401k.
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anon_investor
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by anon_investor »

dlrkw9mu wrote: Sun Jan 10, 2021 9:04 pm
johnanglemen wrote: Sun Jan 10, 2021 8:38 pm
sailaway wrote: Sun Jan 10, 2021 8:36 pm It depends on their tax bracket, years to retirement, expected income in retirement, whether or not they want to do backdoor Roth....

The third option is contributions to Roth IRA, earnings to tIRA.
Can you share how backdoor Roth factors in? They actually have been doing that every year. Does that only come into play if/once they send the earnings to tIRA and contributions to Roth (because then there's a pro rata problem)?
not the original commenter- but right. Some plans will allow in-service roll-over contributions, though. Meaning they may be able to roll after-tax contributions to a Roth IRA, after-tax earnings to a traditional IRA, and then roll the traditional IRA funds back into the traditional 401k.
+1 to this if possible.
SnowBog
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by SnowBog »

anon_investor wrote: Sun Jan 10, 2021 9:05 pm
dlrkw9mu wrote: Sun Jan 10, 2021 9:04 pm
johnanglemen wrote: Sun Jan 10, 2021 8:38 pm
sailaway wrote: Sun Jan 10, 2021 8:36 pm It depends on their tax bracket, years to retirement, expected income in retirement, whether or not they want to do backdoor Roth....

The third option is contributions to Roth IRA, earnings to tIRA.
Can you share how backdoor Roth factors in? They actually have been doing that every year. Does that only come into play if/once they send the earnings to tIRA and contributions to Roth (because then there's a pro rata problem)?
not the original commenter- but right. Some plans will allow in-service roll-over contributions, though. Meaning they may be able to roll after-tax contributions to a Roth IRA, after-tax earnings to a traditional IRA, and then roll the traditional IRA funds back into the traditional 401k.
+1 to this if possible.
+1 as well.

If not possible, then they'll have to figure out impact to Backdoor Roth, if they just roll it to tIRA. But I'd personally still roll the earnings to a tIRA (or just bite the bullet and pay the tax) so I could prioritize Mega Backdoor Roth, mainly because it generally is bigger.

While it sucks, this is a good problem to have, few people have a Mega Backdoor option.
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johnanglemen
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

Thanks for the tip here. I gather from these responses that it's not possible to just *only* move the contributions to Roth IRA without touching earnings at all? They must divide both at once into Traditional and Roth IRA, then request the Traditional IRA to go back into the aftertax subaccount?

And if they do that, then there's no impact on backdoor Roth? (What stops it from being a problem, exactly, given that for a portion of the year, there will have been pretax earnings in the Traditional IRA?)

What about sending the basis and earnings to Traditional and Roth 401k, respectively -- is that possible?
TallBoy29er
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by TallBoy29er »

For a moment I was thinking I was your friend. Out of neglect, I had the same problem recently. I need to add the story to the investing mistakes thread. :oops:

Your friend's best bet is to call the 401k administrator and ask them the good questions you are asking us...you could even be on the phone with them. Different plans offer different options that are documented in their plan documentation, and the admin will be able to tell you what those are (again, your questions are key). I'm in the camp of just biting the bullet, pay the tax, and roll into the Roth...that is what I did. Chalk the tax up to a mistake, and enjoy the future Roth gains.

FYI...my plan offers the option of having all after-tax contributions immediately rolled into the Roth 401k option. This is a new feature. You may ask if your friends has the same. You'll never have to worry about forgetting to convert, or paying gains, again.

Best of luck.
SnowBog
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by SnowBog »

Ultimately, this is highly dependent on their specific plan. So take everything offered with a grain of salt, as it may or may not apply. As previous poster noted, best to contact administrator.

But in my experience/plan I basically have these options:
  • Convert 100% "in plan" and pay taxes on the gains
  • Convert 100% to a Roth IRA and pay taxes on the gains
  • Convert 100% of after-tax basis to Roth IRA, and all "gains" to a Traditional IRA (no taxes currently owed)
If you can do the last one, and 401k let's you roll in the tIRA back into the 401k, that seemingly would be the ideal option. (No immediate taxes, nothing in the way of future Backdoor/Mega...)

If you can't roll the tIRA back in, then you are left with a tIRA balance, which will interfere with future Backdoor Roth. (Mega Roth will be fine though...) Specifically, you'll get hit with pro-rata taxes on conversions. For simple math, let's say gains of $12k + $6k new contributions, I believe that makes 1/3 ($6k/$18k) of Backdoor Roth taxed. Hence, it's better to get rid of the tIRA. But maybe this let's them convert 50% this year (eating 1/2 the tax) and the rest next year (or over some other period of time) if they can't/don't want to absorb the taxes all at once.
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johnanglemen
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

SnowBog wrote: Sun Jan 10, 2021 10:09 pm Ultimately, this is highly dependent on their specific plan. So take everything offered with a grain of salt, as it may or may not apply. As previous poster noted, best to contact administrator.

But in my experience/plan I basically have these options:
  • Convert 100% "in plan" and pay taxes on the gains
  • Convert 100% to a Roth IRA and pay taxes on the gains
  • Convert 100% of after-tax basis to Roth IRA, and all "gains" to a Traditional IRA (no taxes currently owed)
If you can do the last one, and 401k let's you roll in the tIRA back into the 401k, that seemingly would be the ideal option. (No immediate taxes, nothing in the way of future Backdoor/Mega...)

If you can't roll the tIRA back in, then you are left with a tIRA balance, which will interfere with future Backdoor Roth. (Mega Roth will be fine though...) Specifically, you'll get hit with pro-rata taxes on conversions. For simple math, let's say gains of $12k + $6k new contributions, I believe that makes 1/3 ($6k/$18k) of Backdoor Roth taxed. Hence, it's better to get rid of the tIRA. But maybe this let's them convert 50% this year (eating 1/2 the tax) and the rest next year (or over some other period of time) if they can't/don't want to absorb the taxes all at once.
Thanks! We'll definitely be checking with her plan. But just so I understand what's even technically possible per regulation:

1) Is there any world in which earnings can go into the Traditional 401k? Or when you say "back into the 401k", are you referring to the aftertax subaccount?

2) What exactly triggers the pro rata rule with respect to Traditional IRA -> Roth IRA backdoor? Does it kick in only when you actually have pre-tax funds sitting in the tIRA at the moment that you do the conversion? Just making sure that having such funds in the tIRA at one point during the year and then rolling them back out won't be an issue for a conversion that's done either before or after that maneuver.
SnowBog
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by SnowBog »

johnanglemen wrote: Mon Jan 11, 2021 1:21 am
SnowBog wrote: Sun Jan 10, 2021 10:09 pm Ultimately, this is highly dependent on their specific plan. So take everything offered with a grain of salt, as it may or may not apply. As previous poster noted, best to contact administrator.

But in my experience/plan I basically have these options:
  • Convert 100% "in plan" and pay taxes on the gains
  • Convert 100% to a Roth IRA and pay taxes on the gains
  • Convert 100% of after-tax basis to Roth IRA, and all "gains" to a Traditional IRA (no taxes currently owed)
If you can do the last one, and 401k let's you roll in the tIRA back into the 401k, that seemingly would be the ideal option. (No immediate taxes, nothing in the way of future Backdoor/Mega...)

If you can't roll the tIRA back in, then you are left with a tIRA balance, which will interfere with future Backdoor Roth. (Mega Roth will be fine though...) Specifically, you'll get hit with pro-rata taxes on conversions. For simple math, let's say gains of $12k + $6k new contributions, I believe that makes 1/3 ($6k/$18k) of Backdoor Roth taxed. Hence, it's better to get rid of the tIRA. But maybe this let's them convert 50% this year (eating 1/2 the tax) and the rest next year (or over some other period of time) if they can't/don't want to absorb the taxes all at once.
Thanks! We'll definitely be checking with her plan. But just so I understand what's even technically possible per regulation:

1) Is there any world in which earnings can go into the Traditional 401k? Or when you say "back into the 401k", are you referring to the aftertax subaccount?

2) What exactly triggers the pro rata rule with respect to Traditional IRA -> Roth IRA backdoor? Does it kick in only when you actually have pre-tax funds sitting in the tIRA at the moment that you do the conversion? Just making sure that having such funds in the tIRA at one point during the year and then rolling them back out won't be an issue for a conversion that's done either before or after that maneuver.
For #1 - its a crazy world - ask the administrator. (But I'd be very surprised if they allow this directly... 401k's have "contribution limits", and this potentially would violate those. So my working through is its more likely - if they allow it - would be to roll them into a Traditional IRA (get it out of the 401k completely) - and then again if the plan allows it roll the traditional IRA back into the 401k (so this is treated as a "rollover" not some conversion/contribution of "pre-tax" in the plan that could create issues with contribution limits).

The problem - as I understand it - is from the 401k's view - there is a pile of "after-tax" money. So you are converting/transferring the entire pile. If the plan allows it, you can "split" the pile of money - such that your original "basis" (aka the money contributed) gets converted to a Roth (Mega Backdoor), and the "gains" (the growth after contribution) gets transferred to a Traditional IRA. But I don't think you can do one without the other (otherwise how do they track the amount "within" the plan). But if the gains go "out" to a Traditional IRA, which can letter be rolled over - and thus "back into" the 401k, they'll come in as a normal tIRA rollover - which is basically pre-tax (since you owe tax on 100% of the gains - same as you would on any pre-tax contributions). So if the plan supports it, the end result is After-Tax "basis" converted to Roth, "gains" converted to "roll-over pre-tax" funds. No taxes should be owed. At least not until the "pre-tax"/"rollover" funds are withdrawn later, and then they'll be taxed as they normally would be at withdrawal...

For #2, IIRC the tax forms its "year end" balances. Basically, what was "last years" tIRA balance, what is the balance at the end of the tax period. So for 2021, my understanding is they have until the end of this year to get rid of a tIRA balance so they don't have pro-rata taxes. I don't think it matters "when" (for either the backdoor or getting rid of the tIRA), just so long as the "beginning" and "end" values are $0. (Otherwise, it will be pro-rata off the balance.) But I've not personally dealt with pro-rata filing - I've always been able to get tIRA to $0 for the year.
Last edited by SnowBog on Mon Jan 11, 2021 12:20 pm, edited 1 time in total.
Alan S.
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by Alan S. »

johnanglemen wrote: Mon Jan 11, 2021 1:21 am
Thanks! We'll definitely be checking with her plan. But just so I understand what's even technically possible per regulation:

1) Is there any world in which earnings can go into the Traditional 401k? Or when you say "back into the 401k", are you referring to the aftertax subaccount?

2) What exactly triggers the pro rata rule with respect to Traditional IRA -> Roth IRA backdoor? Does it kick in only when you actually have pre-tax funds sitting in the tIRA at the moment that you do the conversion? Just making sure that having such funds in the tIRA at one point during the year and then rolling them back out won't be an issue for a conversion that's done either before or after that maneuver.
1) No. This is not allowed because such a rollover would mix after tax sub account money source with pre tax sources. It is the source that drives plan accounting, so even though earnings in the sub account will be taxable, they were generated by an after tax contribution source. But when these same earnings are rolled to a TIRA, the original source is erased as this has now becomes IRA money. The pre tax (ONLY pre tax) IRA money can then be rolled back into a rollover pre tax sub account in the 401k if the 401k accepts IRA rollovers. Pretty arcane, but it's really only one additional rollover.

2) Unlike employer plans, the taxable amount of an IRA conversion (including back door) conversion can only be determined at year end. The current year end value of all non Roth IRAs goes on line 6 of Form 8606, and is then pro rated with your IRA basis (non deductible contributions). Accordingly, the balance in the TIRA at the exact time of the conversion does not matter in determining the taxable portion of the conversion. The "one point" during the year that matters is year end. Finally, since IRA conversions are no longer eligible for recharacterization since 2018 started, it is risky to do the conversion first, because if the IRA to 401k rollover cannot be done, then you are stuck with a mostly taxable conversion. Again, you could have pre tax dollars in your IRA for several months and that does not matter as long as they can be rolled to an accepting employer plan by 12/31.
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johnanglemen
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

Alan S. wrote: Mon Jan 11, 2021 12:20 pm
johnanglemen wrote: Mon Jan 11, 2021 1:21 am
Thanks! We'll definitely be checking with her plan. But just so I understand what's even technically possible per regulation:

1) Is there any world in which earnings can go into the Traditional 401k? Or when you say "back into the 401k", are you referring to the aftertax subaccount?

2) What exactly triggers the pro rata rule with respect to Traditional IRA -> Roth IRA backdoor? Does it kick in only when you actually have pre-tax funds sitting in the tIRA at the moment that you do the conversion? Just making sure that having such funds in the tIRA at one point during the year and then rolling them back out won't be an issue for a conversion that's done either before or after that maneuver.
1) No. This is not allowed because such a rollover would mix after tax sub account money source with pre tax sources. It is the source that drives plan accounting, so even though earnings in the sub account will be taxable, they were generated by an after tax contribution source. But when these same earnings are rolled to a TIRA, the original source is erased as this has now becomes IRA money. The pre tax (ONLY pre tax) IRA money can then be rolled back into a rollover pre tax sub account in the 401k if the 401k accepts IRA rollovers. Pretty arcane, but it's really only one additional rollover.
Sorry - in this scenario, are you saying that the money would end up back in a special subaccount of the 401k that is not the Traditional bucket, not the Roth bucket, and not the aftertax bucket, but a distinct pretax rollover bucket? :shock:
SnowBog
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by SnowBog »

Again, highly depends on the plan. Best to check with the plan administrator.

For myself/my plan, all pre-tax money, be it my contributions, employer match, or any rollover from prior tIRA/401k is all treated simply as "pre-tax".

But if I look at "sources" in my plan, I'll see these amounts broken out. So while all of the money is treated the same [in my plan anyway] I can see that roughly 50% is from rollovers of other plans, 33% is from my contributions, and the balance is employer match.

Their plan might treat rollover differently, so it's best to check.
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by placeholder »

johnanglemen wrote: Mon Jan 11, 2021 2:26 pm Sorry - in this scenario, are you saying that the money would end up back in a special subaccount of the 401k that is not the Traditional bucket, not the Roth bucket, and not the aftertax bucket, but a distinct pretax rollover bucket?
Yes which can be important like at megacorp where rollover contributions can be rolled back out without restriction but not pretax contributions or matching.
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johnanglemen
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

Thanks for the advice, all. We've made good progress and friend executed a split rollover today, to be completed tomorrow. When that's complete, they will do a rollover from the traditional IRA back into the pretax 401k and leave the contributions in the Roth IRA.

One last question -- they are currently scheduled to have another aftertax contribution from their paycheck later this week. Is there any reason not to turn on autoconvert now so that that contribution immediately converts to Roth? The state of the world at the time that that happens should be: aftertax subaccount is empty (except for that new contribution itself) + previous earnings in traditional IRA awaiting rollover to pretax 401k + previous aftertax contributions sitting pretty in Roth IRA.
ofckrupke
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by ofckrupke »

Alan S.,
Alan S. wrote: Mon Jan 11, 2021 12:20 pm
johnanglemen wrote: Mon Jan 11, 2021 1:21 am
Thanks! We'll definitely be checking with her plan. But just so I understand what's even technically possible per regulation:

1) Is there any world in which earnings can go into the Traditional 401k? Or when you say "back into the 401k", are you referring to the aftertax subaccount?

2) What exactly triggers the pro rata rule with respect to Traditional IRA -> Roth IRA backdoor? Does it kick in only when you actually have pre-tax funds sitting in the tIRA at the moment that you do the conversion? Just making sure that having such funds in the tIRA at one point during the year and then rolling them back out won't be an issue for a conversion that's done either before or after that maneuver.
1) No. This is not allowed because such a rollover would mix after tax sub account money source with pre tax sources. It is the source that drives plan accounting, so even though earnings in the sub account will be taxable, they were generated by an after tax contribution source. But when these same earnings are rolled to a TIRA, the original source is erased as this has now becomes IRA money. The pre tax (ONLY pre tax) IRA money can then be rolled back into a rollover pre tax sub account in the 401k if the 401k accepts IRA rollovers. Pretty arcane, but it's really only one additional rollover.
can you explain to me how this split-distribution briskly followed by reverse rollover of the pre-tax money back into the same employer plan does not run afoul of the step transaction doctrine? Is the fact that the taxable earnings part doesn't end up back in the after-tax source sleeve, but instead in a different (IRA rollover) source sleeve, the fig leaf here? Otherwise, what makes the outcome sufficiently distinct from just having decanted the after-tax basis, without earnings, out of the plan...to a Roth IRA (which as a single step operation wouldn't be allowed)?
Alan S.
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by Alan S. »

I consider the levying of illegal step transaction penalties to be a highly arbitrary and subjective process, for which the IRS has no operations manual. Therefore, given all the retirement account portability expansions in the last two decades for which the IRS has declined to flag, it is probably safe to not worry about it until it happens.

Blessing the back door Roth strategy is another indication that the IRS does not have the appetite to find certain step transactions as illegal, even when they become popular enough to show up across the financial press. But sometimes the ax does fall, such as the wash sale rules involving IRA accounts.

The IRS may one day find certain portability actions such as the subject rollovers to be illegal step transactions, but I would not worry about it until it happens. If and when it does, the news will spread far and wide.
SnowBog
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by SnowBog »

johnanglemen wrote: Tue Jan 12, 2021 5:28 pm Is there any reason not to turn on autoconvert now so that that contribution immediately converts to Roth?
Again, highly dependent on their plan and their target end state.

But given all the extra work you just went through, automating conversions seems like a great idea! Automate so they never forget again.

The only potential "gotcha", some plans may not allow (or might be harder, or might have a fee, or only allow after you are no longer employed, or...) you to withdraw [converted] Roth funds from the 401k to a separate Roth IRA.

(There are arguably advantages to leaving it in 401k such as better creditor protections. There are arguably advantages to getting it into a Roth such as more investing choices and easier to access pre- 59.5. Unless they have a specific target end state, it may not matter that much. Automate away!)

Ultimately though, so long as the money ends up as a Roth, to me that's a huge win.
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johnanglemen
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by johnanglemen »

SnowBog wrote: Tue Jan 12, 2021 11:01 pm
johnanglemen wrote: Tue Jan 12, 2021 5:28 pm Is there any reason not to turn on autoconvert now so that that contribution immediately converts to Roth?
Again, highly dependent on their plan and their target end state.

But given all the extra work you just went through, automating conversions seems like a great idea! Automate so they never forget again.

The only potential "gotcha", some plans may not allow (or might be harder, or might have a fee, or only allow after you are no longer employed, or...) you to withdraw [converted] Roth funds from the 401k to a separate Roth IRA.

(There are arguably advantages to leaving it in 401k such as better creditor protections. There are arguably advantages to getting it into a Roth such as more investing choices and easier to access pre- 59.5. Unless they have a specific target end state, it may not matter that much. Automate away!)

Ultimately though, so long as the money ends up as a Roth, to me that's a huge win.
This is a good point, I forgot about creditor 401k protections. To be clear, would my friend have been able to choose to send the contribution portion to Roth 401k instead of Roth IRA (legally, I mean -- if their plan supported it)? Or can each portion (legally) only go into IRAs if you're doing this kind of split rollover?
SnowBog
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by SnowBog »

Not entirely sure... My assumption is it's either an "in plan" conversion (in full) or a transfer/rollover to an external account(s) where you can split gains into tIRA.
ofckrupke
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Re: Forgot to do in-service withdrawal/conversion of mega backdoor

Post by ofckrupke »

Alan S. wrote: Tue Jan 12, 2021 8:03 pm I consider the levying of illegal step transaction penalties to be a highly arbitrary and subjective process, for which the IRS has no operations manual. Therefore, given all the retirement account portability expansions in the last two decades for which the IRS has declined to flag, it is probably safe to not worry about it until it happens.

Blessing the back door Roth strategy is another indication that the IRS does not have the appetite to find certain step transactions as illegal, even when they become popular enough to show up across the financial press. But sometimes the ax does fall, such as the wash sale rules involving IRA accounts.

The IRS may one day find certain portability actions such as the subject rollovers to be illegal step transactions, but I would not worry about it until it happens. If and when it does, the news will spread far and wide.
Thanks for sharing your seasoned perspective.
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