How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

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Topic Author
john1984
Posts: 29
Joined: Tue Aug 04, 2020 1:37 pm

How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by john1984 »

During the holidays, I am researching mega Roth through Roth 401k.
The automatic feature is very attractive compared to making a call every month.

It is clear that without in-plan roth rollovers, the Roth 401k deferral will be combined with Roth IRA regular basis, the Roth 401k earnings will be combined with Roth IRA earnings. This is consistent with 8606 Line 22 instruction. Very good.

I thought that the in-plan roth rollover was also part of the Roth 401k basis, and should be treated the same way as Roth 401k deferrals, i.e. when rolled over to Roth IRA, they are regarded as Roth IRA regular contributions.

However, this seems to contradict to the wisdom of this forum. Retiredjg wrote a very nice and clear post(viewtopic.php?p=4175886#p4175886), let me quote
retiredjg wrote: Sun Oct 21, 2018 8:59 am I think a Roth 401k could contain these things*:
  • direct contributions to Roth 401k (contribution)

    conversion of pre-tax elective deferrals to Roth 401k (conversion with a 5 year clock)

    rollover/conversion of after-tax account to Roth 401k (the after-tax contribution would be contributions and the earnings that were taxable would be a conversion with a 5 year clock)

    earnings that have occurred after the money got inside the Roth 401k (this is neither a contribution nor a conversion)
I think what Alan is telling us is that all of these things maintain their exact character if rolled from Roth 401k to Roth IRA. Contributions remain contributions, conversions remain conversions along with their individual clocks, and earnings remain earnings and fall to the bottom of the stack to join the earnings in the Roth IRA. These are the "earnings" that are in the kawill table.
So in-plan Roth rollovers to Roth 401k are like conversions to Roth IRA?
After a Roth 401k to Roth IRA rollover, those in-plan Roth rollovers will be combined with the Roth conversions in the Roth IRA occurred at the same year, taxable portion with the taxable portion, non-taxable portion with the non-taxable portion?

I tried to confirm with Alan's post, and found this(viewtopic.php?p=4446512#p4446512):
Alan S. wrote: Wed Mar 20, 2019 2:00 pm However, the 8606 Inst for lines 22 and 24 and the following IRS Reg https://www.law.cornell.edu/cfr/text/26/1.408A-10 were never updated to incorporate in plan Roth rollovers (IRRs) rolled into a Roth IRA. Despite the IRRs being part of the "investment in the contract" in the Roth 401k, these amounts should go on line 24 of Form 8606, not on 22.

A qualified rollover contribution from the pre tax portion of a 401k to a Roth IRA including the so called mega back door conversion should be reported on line 24 of Form 8606. All of these line 24 amounts come out of the Roth IRA under the ordering rules and to further complicate things, Roth conversions, qualified rollover contributions, and direct rollovers from a Roth 401k all go into the 5 year queue for purposes of determining which pre tax amounts are subject to the 10% recapture tax prior to 59.5.

Therefore, if you are rolling multiple portions of a qualified plan into your Roth IRA as well as ordinary TIRA to Roth conversions, you have some complicated accounting rules and tracking work to be done should you ever take a non qualified Roth IRA distribution.
Aw, how could one know that the tax form instructions and IRS Regulations are outdated!

So is there any official source that attests retiredjg and Alan's treatments of IRRs?
Or is it a known convention in the accounting industry, even with the lack of clear IRS regulations?

I do not intend to challenge retiredjg and Alan. After searching online for a long time, I just feel the anxiety to know exactly that this is indeed the correct way to record IRRs on my Roth table.

Thanks :happy !

John
Alan S.
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Location: Prescott, AZ

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Alan S. »

John, glad you questioned this, as I stand corrected on showing IRRs on line 24 of Form 8606. The 8606 instructions state that "line 22 of Form 8606 should be increased to reflect amounts rolled if from a designated Roth account that are treated as investment in the contract". These amounts will also be reported on the 1099R from the Roth 401 in Box 5. That said, this makes no sense to me.

Even though the IRS Reg 1.408A-10 has not been updated to address Roth IRA distributions attributed to rollover contributions from a Roth 401k with IRRs, the main citation addressing the 10% recapture tax for IRRs comes from IRS Notice 2010-84, p 2. I added bold text to the applicable sentence:
Section 408A(d)(3)(F) of the Code provides that any distribution from a
Roth IRA that is allocable to the taxable amount of a rollover to the Roth IRA
(other than from another Roth IRA or a designated Roth account) made within
the preceding 5 taxable years is treated as includible in gross income for
purposes of applying the 10% additional tax under § 72(t). The 5-year recapture
rule also applies if the rollover to the Roth IRA is from a designated Roth account
and the distribution is allocable to the taxable amount of an in-plan Roth rollover
made within the preceding 5 years.
The IRS is not providing any instruction how to integrate IRRs made within 5 years with the other amounts on line 22. When do these IRRs under a 5 year aging requirement for Sec 72t (the 10% penalty) come out relative to other line 22 amounts? All line 22 amounts are commingled and are distributed first under the Roth IRA ordering rules. If these had been placed on line 24 along with qualified rollover and Roth conversions as I anticipated incorrectly, the taxpayer would know exactly when the taxable portion of an IRR would come out. I consider this a flaw in IRS guidance until someone can explain why the IRS made the decision to report these IRRs on line 22.

The taxpayer is responsible for completing Part III of the 8606, and the IRS has not been questioning the line 22 or 24 amounts, so this is probably not causing tax problems with tax software and the IRS likely does not even have this on their radar.
Topic Author
john1984
Posts: 29
Joined: Tue Aug 04, 2020 1:37 pm

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by john1984 »

Hi Alan,

I am excited that you replied!
The 5-year recapture rule also applies if the rollover to the Roth IRA is from a designated Roth account and the distribution is allocable to the taxable amount of an in-plan Roth rollover made within the preceding 5 years.
Yeah this is indeed an evidence that the IRS intends to carry out the 5 year penalty for IRRs even after rolling it over to Roth IRA.
The IRS is not providing any instruction how to integrate IRRs made within 5 years with the other amounts on line 22. When do these IRRs under a 5 year aging requirement for Sec 72t (the 10% penalty) come out relative to other line 22 amounts? All line 22 amounts are commingled and are distributed first under the Roth IRA ordering rules. If these had been placed on line 24 along with qualified rollover and Roth conversions as I anticipated incorrectly, the taxpayer would know exactly when the taxable portion of an IRR would come out. I consider this a flaw in IRS guidance until someone can explain why the IRS made the decision to report these IRRs on line 22.
I see the rationale now. To enforce the 5-year recapture rule, the IRS needs to track the 5 year clock.
The only way to prevent it from evading the 5-year clock in a Roth 401k to Roth IRA rollover is to combine the IRR accounting with the Roth IRA conversions. It makes sense. Thanks.

I do want to ask you a few more questions about the instruction. Forgive me if there are elementary questions.
The 8606 instructions state that "line 22 of Form 8606 should be increased to reflect amounts rolled if from a designated Roth account that are treated as investment in the contract".
For curiosity, what is "investment in the contract" :confused ? It is a mysterious word that often appears in the Revenue Code, but I usually either ignore it or replace it with "basis" (I do not seem to understand the word "basis" either...). Here it actually matters: according to the context of your reply, it means Roth 401k contribution + IRR (conversion basis?)?
These amounts will also be reported on the 1099R from the Roth 401 in Box 5. That said, this makes no sense to me.
I checked 1099R instruction Box 5
... Generally, this shows the employee’s investment in the contract (after-tax contributions), if any, recovered tax free this year; the portion that’s your basis in a designated Roth account; ...
Here comes the "investment in the contract" again. So does the basis here mean just the Roth 401k deferral?
Dovahkiin
Posts: 198
Joined: Thu Jan 26, 2012 11:36 pm

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Dovahkiin »

I'd try to keep as many records as you can. Keep every statement you have showing what is clearly contributions, earnings, etc. Keep every 1099-R, so in an audit you'll likely to prevail if you make large withdrawals from a Roth before 59 1/2.

Unfortunately, Roth 401ks differ in one area between Roth IRAs for early withdrawals, and that is:
Early withdrawals are prorated between nontaxable contributions and earnings.
https://www.investopedia.com/ask/answer ... -rules.asp

Which is why it's commingled on line 22 for the 8606! So you can absolutely withdraw your employee contributions (the $19,500 limit) to the Roth 401k tax and penalty free, but if it's non-deductible contributions they come out pro-rated mixed with the earnings.

So lets say we have this example:

Empty Roth 401k.

$19,500 contribution to Roth 401k.
$37,500 non-deductible 401k contribution converted in-plan to the Roth 401k.

Stock market went up 10% in the account after everything was converted.

$62700 account, $5,700 earnings.

Withdraw the first $19,500 - that comes out tax and penalty free.

Now you have $5,700 earnings + $37,500 of non-deductible contributions. For each dollar you withdraw before 59 1/2 13.19% of that will be taxable and subject to a penalty. (Math = 5700/ (5700+37500) = 13.19%)

If the above example was a Backdoor Roth IRA(non deductible IRA to IRA) instead built up over several years, then you could withdraw the next $37,500 tax and penalty free.

So, the IRS is looking to try to enforce the Roth 401k ordering rules as much as possible when you convert it to a Roth IRA. At least, that is my explanation as to what the IRS is attempting to do by that guidance. They don't want you to get the more favorable non-deductible IRA contribution conversion withdrawal rules.
Ben B
Posts: 26
Joined: Thu Dec 17, 2020 11:17 am

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Ben B »

Dovahkiin wrote: Mon Dec 28, 2020 4:19 am I'd try to keep as many records as you can. Keep every statement you have showing what is clearly contributions, earnings, etc. Keep every 1099-R, so in an audit you'll likely to prevail if you make large withdrawals from a Roth before 59 1/2.

Unfortunately, Roth 401ks differ in one area between Roth IRAs for early withdrawals, and that is:
Early withdrawals are prorated between nontaxable contributions and earnings.
https://www.investopedia.com/ask/answer ... -rules.asp

Which is why it's commingled on line 22 for the 8606! So you can absolutely withdraw your employee contributions (the $19,500 limit) to the Roth 401k tax and penalty free, but if it's non-deductible contributions they come out pro-rated mixed with the earnings.

So lets say we have this example:

Empty Roth 401k.

$19,500 contribution to Roth 401k.
$37,500 non-deductible 401k contribution converted in-plan to the Roth 401k.

Stock market went up 10% in the account after everything was converted.

$62700 account, $5,700 earnings.

Withdraw the first $19,500 - that comes out tax and penalty free.

Now you have $5,700 earnings + $37,500 of non-deductible contributions. For each dollar you withdraw before 59 1/2 13.19% of that will be taxable and subject to a penalty. (Math = 5700/ (5700+37500) = 13.19%)

If the above example was a Backdoor Roth IRA(non deductible IRA to IRA) instead built up over several years, then you could withdraw the next $37,500 tax and penalty free.

So, the IRS is looking to try to enforce the Roth 401k ordering rules as much as possible when you convert it to a Roth IRA. At least, that is my explanation as to what the IRS is attempting to do by that guidance. They don't want you to get the more favorable non-deductible IRA contribution conversion withdrawal rules.
What if the $37,500 non-deductible 401k contribution was converted directly to a Roth IRA, would that avoid this issue?
Alan S.
Posts: 10840
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Alan S. »

john1984 wrote: Mon Dec 28, 2020 2:49 am Hi Alan,

I am excited that you replied!
The 5-year recapture rule also applies if the rollover to the Roth IRA is from a designated Roth account and the distribution is allocable to the taxable amount of an in-plan Roth rollover made within the preceding 5 years.
Yeah this is indeed an evidence that the IRS intends to carry out the 5 year penalty for IRRs even after rolling it over to Roth IRA.
The IRS is not providing any instruction how to integrate IRRs made within 5 years with the other amounts on line 22. When do these IRRs under a 5 year aging requirement for Sec 72t (the 10% penalty) come out relative to other line 22 amounts? All line 22 amounts are commingled and are distributed first under the Roth IRA ordering rules. If these had been placed on line 24 along with qualified rollover and Roth conversions as I anticipated incorrectly, the taxpayer would know exactly when the taxable portion of an IRR would come out. I consider this a flaw in IRS guidance until someone can explain why the IRS made the decision to report these IRRs on line 22.
I see the rationale now. To enforce the 5-year recapture rule, the IRS needs to track the 5 year clock.
The only way to prevent it from evading the 5-year clock in a Roth 401k to Roth IRA rollover is to combine the IRR accounting with the Roth IRA conversions. It makes sense. Thanks.

I do want to ask you a few more questions about the instruction. Forgive me if there are elementary questions.
The 8606 instructions state that "line 22 of Form 8606 should be increased to reflect amounts rolled if from a designated Roth account that are treated as investment in the contract".
For curiosity, what is "investment in the contract" :confused ? It is a mysterious word that often appears in the Revenue Code, but I usually either ignore it or replace it with "basis" (I do not seem to understand the word "basis" either...). Here it actually matters: according to the context of your reply, it means Roth 401k contribution + IRR (conversion basis?)?
These amounts will also be reported on the 1099R from the Roth 401 in Box 5. That said, this makes no sense to me.
I checked 1099R instruction Box 5
... Generally, this shows the employee’s investment in the contract (after-tax contributions), if any, recovered tax free this year; the portion that’s your basis in a designated Roth account; ...
Here comes the "investment in the contract" again. So does the basis here mean just the Roth 401k deferral?
"Investment in the Contract" is an old annuity term for the premium paid. Essentially, extended to other retirement accounts this is referred to as "basis". I am not aware of any meaningful difference between these two terms. In retirement accounts basis is the amount contributed on which taxes have already been paid. Form 8606 uses the term "non deductible contributions as well, but mostly uses "basis" including on lines 22 and 24 of Part III. The IRS frequently uses the same term for multiple situations. In short, consider all these terms synonymous in principle.

IRRs are definitely basis in a Roth 401k, just as conversions are basis in a Roth IRA. Taxes are due on pre tax portions of IRRs and conversions, but once in the Roth accounts they are basis. In a Roth IRA, basis is split between lines 22 and 24 because of Roth IRA ordering rules. Line 22 is distributed first.

Back to the main issue, by stating that IRRs moved into a Roth IRA go on line 22 rather than 24 still makes no sense to me. We know that the 5 year holding requirement for the taxable portions of IRRs and conversions operate the same. The age of IRRs once in the Roth IRA can be tracked by the IRA owner, but once these IRRs go on line 22, there is no IRS guidance on determining when they are distributed. The 5 year holding period for IRRs only matters if they are distributed in the first 5 years of the IRR. Since line 22 balance is distributed prior to any line 24 balance, IRR money comes out of a Roth IRA before conversion money, but we still don't know when that is in relation to regular Roth IRA contributions and Roth 401k deferrals which are also on line 22.

So I was quite surprised when you pointed out that this IRR money goes on 22. I will look into this further and get back to you.
Dovahkiin
Posts: 198
Joined: Thu Jan 26, 2012 11:36 pm

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Dovahkiin »

Alan S. wrote: Mon Dec 28, 2020 1:30 pm So I was quite surprised when you pointed out that this IRR money goes on 22. I will look into this further and get back to you.
I'm not a CPA, just trying to provide insight into why the IRS may have decided what they did. At this point I highly suggest you talk with a CPA about these issues as it's way above my head. I've never done any sort of roth 401k rollovers.

Sorry, looking over it again, line 22 is contributions so you'd have your basis of that plus the $19,500/annual limit of the 401k. Line 24 is where you'd track the conversions.

And yes, it probably would have been better if you can have gone from After-tax 401k -> Roth IRA directly as you'd have the much more favorable early withdrawal rules. It's a grey area if you did After-Tax -> Roth 401k -> Roth IRA. You can certainly try to treat the after tax portion ultimately as if you did After-Tax -> Roth IRA directly.

The 8606 isn't an authority of basis for Roth IRAs after all. It's only the authority of basis for non-deductible IRAs. The tax payer is responsible to keep track of the Roth IRA basis themselves.

I'd talk with a CPA and ask them if it's okay to treat non-deductible conversions from a 401k non-pro-rata once they're in the Roth IRA. In essence, it'd be exactly the same as if you did After-Tax -> Roth IRA. (After all, you still had to track the non-deductible non-taxable portion in the Roth 401k.)

For my Roth IRA I keep a spreadsheet showing each year what back-door conversion I did, contribution, etc. No matter what I do with my tax program, TaxAct, it doesn't spit out numbers on lines 6-12 on the 8606, showing a Roth Conversion, which is a known issue:
https://forum.whitecoatinvestor.com/ret ... 8606-issue

I have many years of having to do the backdoor roth IRA contribution method.

While people at the WhiteCoatInvestor say it's fine - the worksheet alternative method TaxAct is apparently using also mentions conversions, it makes me nervous as it looks like on the 8606 I make a contribution and a withdrawal every year from the T-IRA, instead of converting it to Roth.

So despite that, I always include an IRA Distribution Explanation statement every year on my tax return: "Non-Deductible T-IRA Contribution Converted to Roth IRA."

It personally makes me nervous if I ever make a huge Roth IRA withdrawal they may wonder why I have such a huge basis with the missing numbers on 6-12. I always keep every IRA statement to show when the conversions happened/keep every 1099-R/etc. I suggest you do the same with your Roth-401k and After-Tax 401k.

So my final suggestion is to talk to a CPA, see if it's reasonable to treat it as if you did After-tax 401k -> Roth IRA directly, as it's certainly reasonable to me. It'd suck to have to be beholden to the stricter Roth-401k withdrawal rules even though it's NOW in a Roth IRA, and it's such an esoteric position even for the IRS I doubt they'd argue it or take it to tax court.

After your discussion with the CPA, fill out lines 22 with your Roth IRA contributions + employee contributions to the Roth 401k. Fill out line 24 as your CPA directs, or if you want to do it yourself, the After-tax 401k's non-taxable basis.

I'd put something on your IRA Distribution Explanation of: "computed on line 22 Roth IRA Contributions with rolled over Roth-401k Employee-Contributions. Computed on line 24 with rolled over After-Tax 401k non-taxable basis."

Finally, all of this only matters when you make a Roth IRA distribution. You don't report anything on the 8606 when you convert a 401k into a Roth IRA. You only report the rollover on line 4.b on your 1040 with the worlds rollover and the information from your 1099-R.

Did you make a Roth IRA distribution?
Alan S.
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Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Alan S. »

No, John1984 asked the question regarding the following situation:

1) IRR (mostly all non taxable), then rolled to a Roth IRA. He located one of my prior posts on this subject and questioned why I indicated that for a Roth IRA distribution, the formerly IRR money should go on line 24. He noticed that the Form 8606 Inst stated that it should instead go on 22. So essentially the IRS is saying while the IRR was tantamount to a conversion, it goes on line 22 with the regular Roth IRA contributions.

This means that for a Roth IRA, basis is broken up between regular and conversion contributions because of the Roth IRA ordering rules. Whereas if the Roth IRA contained a rollover from a Roth 401k with an IRR (even under 5 years age), the basis should not be broken up between regular and conversion, it should all be regular. The taxpayer is still expected to pay a penalty on the taxable amount of an IRR if distributed within 5 years, that is in an IRS Notice.

But if you combine the IRR money with regular contributions, there is no way to determine when that money is distributed v. the rest of the Roth regular contributions, and without knowing that you cannot address the penalty.

Note that this issue has almost no practical effect for a mega back door IRR since almost the entire IRR is non taxable. It's more of an academic question, why the 8606 Inst for line 22 state this:
• Increase the amount on line 22 by
any amount rolled in from a designated
Roth account that is treated as
investment in the contract.
My guess would be that the IRS never thought about IRRs here. This would have been correct prior to IRRs, but it makes no sense when the investment in the contract includes IRRs. And again, if the IRR money goes on line 22, how do you know when it has been distributed or not. There are no Roth IRA ordering rules within the regular contributions category.
Topic Author
john1984
Posts: 29
Joined: Tue Aug 04, 2020 1:37 pm

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by john1984 »

Dovahkiin wrote: Mon Dec 28, 2020 2:38 pm
I'm not a CPA, just trying to provide insight into why the IRS may have decided what they did. At this point I highly suggest you talk with a CPA about these issues as it's way above my head. I've never done any sort of roth 401k rollovers.
...
I'd talk with a CPA and ask them if it's okay to treat non-deductible conversions from a 401k non-pro-rata once they're in the Roth IRA. In essence, it'd be exactly the same as if you did After-Tax -> Roth IRA. (After all, you still had to track the non-deductible non-taxable portion in the Roth 401k.)

...
So despite that, I always include an IRA Distribution Explanation statement every year on my tax return: "Non-Deductible T-IRA Contribution Converted to Roth IRA."
...
So my final suggestion is to talk to a CPA, see if it's reasonable to treat it as if you did After-tax 401k -> Roth IRA directly, as it's certainly reasonable to me. It'd suck to have to be beholden to the stricter Roth-401k withdrawal rules even though it's NOW in a Roth IRA, and it's such an esoteric position even for the IRS I doubt they'd argue it or take it to tax court.

After your discussion with the CPA, fill out lines 22 with your Roth IRA contributions + employee contributions to the Roth 401k. Fill out line 24 as your CPA directs, or if you want to do it yourself, the After-tax 401k's non-taxable basis.

...

Finally, all of this only matters when you make a Roth IRA distribution. You don't report anything on the 8606 when you convert a 401k into a Roth IRA. You only report the rollover on line 4.b on your 1040 with the worlds rollover and the information from your 1099-R.

Did you make a Roth IRA distribution?
Thanks Dovahkiin for sharing your experience and giving comprehensive suggestions.

It is not a practical problem for me now. But I plan to make Roth distribution in about 3 years, so I will eventually file a 8606.

The discussion we had is about Alan's approach of putting IRRs on Line 24 vs 8606 instructions of putting it on Line 22. But in practice it should hardly affect my tax liability, because I have very little (a few cents) earnings of after-tax account rolled over to my Roth IRA. So if I choose after-tax 401k -> Roth 401k-> Roth IRA in the future, Alan's approach in the worst case will make me pay a few cents in tax. To be safe, I will just put it on Line 24 and pay a few more cents.

It is as Alan said an academic question. As I read more and more tax documents, I become more curious about those questions even though it has little practical impact.
So lets say we have this example:

Empty Roth 401k.

$19,500 contribution to Roth 401k.
$37,500 non-deductible 401k contribution converted in-plan to the Roth 401k.

Stock market went up 10% in the account after everything was converted.

$62700 account, $5,700 earnings.

Withdraw the first $19,500 - that comes out tax and penalty free.
Let me discuss your example. Let us assume that the contribution was made in 2020. And the distribution is also made in 2020. So in the Roth 401k account prior to the distribution, we have
$19,500: elective deferral, or employee contribution
$37,500: in-plan Roth rollover that was taxed upon entering into Roth 401k
$5,700: earning, gain or income as opposed to the investment in the contract

If I'm in service, then the elective deferral can not be distributed until I reach the age of 59.5. That also comes from Alan's post(viewtopic.php?p=3723961#p3723961)
Regular Roth 401k contributions are elective deferrals and therefore cannot be distributed in service (non hardship) until age 59.5.
Earnings may be distributable depending on plan provisions.
There will be no employer match in the account because the match must go to the pre tax 401k.
...
However, IRRs composed of per tax elective deferrals can never be distributed before 59.5 in service.
...
(Alan, may I request for the source for this? It seems to be a hard rule cited across introductory articles)

So the distribution will be prorated between the $37,500, and $5,700.

Let's say I distribute $1,000. Then
1,000 * 37,500/(37,500+5,700) = 868 will be non-taxable
1,000 * 5,700/(37,500+5,700) = 132 will be taxable as income, +10% penalty as non-qualified distribution of gain

In addition, the 868, though not taxable, belongs to IRR made within 5 years. Therefore the additional 10% penalty applies.
For the $1,000 withdrawal, I will pay income tax from the $132 income + $13.2 for unqualified distribution of the gain + $86.8 penalty tax for the IRR.

This is the same calculation done in IRS Notice 2010-84, A-13 example.

OK. Now if I am separated from service at the time of distribution (fired!), then I may be allowed to distribute the elective deferrals.
My guess is that it will prorate the entire amount $62,700. Thus
1,000 * 3,7500 / 62,700 = 598 will be nontaxable, however there is a 10% penalty for IRRs within 5 years
1,000 * 5,700/ 62,700 = 91 will be taxable as income, +10% penalty as non-qualified distribution of gain
1,000 * 19,500 / 62,700 = 311 will be nontaxable

Noticeably, the IRS permits a favorable rule if the distribution is a partial rollover.
Either in-service or separated from the service, if I distribute $6,000, and rollover $5,700 into a Roth IRA, then the $5,700 will be counted as the gains in the Roth 401k, and the rest $300 taken into my pocket is tax free!

This is according to CFR 402A-1, A-5 (d) (link: https://www.law.cornell.edu/cfr/text/26/1.402A-1)
Example.
Employee B receives a $14,000 eligible rollover distribution that is not a qualified distribution from B's designated Roth account, consisting of $11,000 of investment in the contract and $3,000 of income. Within 60 days of receipt, Employee B rolls over $7,000 of the distribution into a Roth IRA. The $7,000 is deemed to consist of $3,000 of income and $4,000 of investment in the contract. Because the only portion of the distribution that could be includible in gross income (the income) is rolled over, none of the distribution is includible in Employee B's gross income.
Now if you ask me how much in this $300 consists of IRRs. I would guess that in the case of in-service distribution, it should completely be composed of IRRs, as elective deferral are not allowed to be distributed before 59.5. In the case of separated from service, I would guess to prorate the 300 among the 19,500 elective deferrals and 37,500 IRRs. But I am not sure.

You and Alan can correct me if there is something wrong in this post.
Thanks!
Last edited by john1984 on Mon Dec 28, 2020 10:43 pm, edited 1 time in total.
Topic Author
john1984
Posts: 29
Joined: Tue Aug 04, 2020 1:37 pm

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by john1984 »

Alan S. wrote: Mon Dec 28, 2020 1:30 pm In retirement accounts basis is the amount contributed on which taxes have already been paid. Form 8606 uses the term "non deductible contributions as well, but mostly uses "basis" including on lines 22 and 24 of Part III. The IRS frequently uses the same term for multiple situations. In short, consider all these terms synonymous in principle.
I was confused whether the conversions belong to the basis. Following this comment, I look more closely on Line 22 and 24 of 8606:
Line 22: Enter your basis in Roth IRA contributions (see instructions)
Line 24: Enter your basis in conversions from traditional, SEP, and SIMPLE IRAs and rollovers from qualified retirement plans to a Roth IRA. See instructions
It says basis in Roth IRA contributions and basis in conversions. Thus it should comprise both, i.e. all the after-tax components in a Roth IRA.
I guess that's what you usually called the regular basis and conversion basis.

Thanks for the clarification.
So I was quite surprised when you pointed out that this IRR money goes on 22. I will look into this further and get back to you.
I look forward to seeing your investigation results.
sfly510
Posts: 27
Joined: Tue Feb 12, 2019 9:23 am

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by sfly510 »

john1984 wrote: Mon Dec 28, 2020 7:12 pm
Alan S. wrote: Mon Dec 28, 2020 1:30 pm So I was quite surprised when you pointed out that this IRR money goes on 22. I will look into this further and get back to you.
I look forward to seeing your investigation results.
Out of curiosity, did anyone get clarification on this?
Alan S.
Posts: 10840
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by Alan S. »

sfly510 wrote: Wed Oct 13, 2021 10:02 am
john1984 wrote: Mon Dec 28, 2020 7:12 pm
Alan S. wrote: Mon Dec 28, 2020 1:30 pm So I was quite surprised when you pointed out that this IRR money goes on 22. I will look into this further and get back to you.
I look forward to seeing your investigation results.
Out of curiosity, did anyone get clarification on this?
Yes, the 8606 Inst. p 9 state the any amount rolled in from a designated Roth that is treated as investment in the contract goes on line 22. IRRs are investments in the contract being since they are contributions. Roth 401k earnings are not investments in the contract until they become qualified per IRS Reg 1.408A-10, QA 3.

Note that Form 8606 reporting of Roth IRA distributions only addresses the income tax

This is not intuitive, but the IRS has therefore determined that an IRR that became an investment in the contract in the Roth 401k prior to being rolled into a Roth IRA is accorded line 22 distribution priority under the Roth IRA ordering rules, while normal conversions and rollovers from pre tax 401k accounts are not since they go on line 24.

Does this mean that IRRs be added to line 22 avoid the 5 year holding requirement with respect to the 10% penalty? No. I originally thought that it did, but the poorly explained Appendix C in Pub 590 B creates a different ordering for penalty purposes than the lines 22 and 24 of Form 8606. That means that the 5 year holding period for an IRR continues to run following a rollover to a Roth IRA, same as for a pre tax 401k rollover to a Roth IRA.
sfly510
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Re: How to characterize in-plan Roth rollover after a Roth 401k mega backdoor?

Post by sfly510 »

As always, thank you, Alan S., for your excellent response.
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