Mega Backdoor ROTH - IRS article on pro-rata

[paddyj]

I would like to request some help on Mega Backdoor Roth strategy and its tax implications.
My employer sponsored 401K plan allows 3 buckets – pretax, ROTH, and after-tax. It is with Vanguard. It allows up to 4 in-service withdrawals in a year. This plan does not allow in-plan conversions to ROTH. Hence, ‘in-service withdrawals’ is my only avenue to execute this strategy. My plan is to make after-tax contributions (not ROTH) and then transfer that amount to my ROTH IRA with Vanguard. I recognize I need to pay taxes on any earnings on my contributions.
Question – Are these transfers subject to pro-rata rule? Will I be required to convert proportionate amount from my traditional pre-tax 401K account balance? My understanding was that the pro-rata rule applies only to IRAs. But this article on IRS website has confused me. It mentions pro-rata rule for any retirement plan. Perhaps I am misunderstanding.
IRS article: https://www.irs.gov/retirement-plans/ro ... ment-plans
I have read previous posts on bogleheads forum on this topic and it seems I should be ok to rollover into my ROTH IRA. But I just wanted to eliminate any concerns based on this IRS article.
Other facts – I don’t have traditional IRA account. I have ROTH IRA with Vanguard which I contribute to each year. Hence, I don’t run into pro-rata issues on backdoor ROTH conversions.

[Moniker]

I would like to request some help on Mega Backdoor Roth strategy and its tax implications.
My employer sponsored 401K plan allows 3 buckets – pretax, ROTH, and after-tax. It is with Vanguard. It allows up to 4 in-service withdrawals in a year. This plan does not allow in-plan conversions to ROTH. Hence, ‘in-service withdrawals’ is my only avenue to execute this strategy. My plan is to make after-tax contributions (not ROTH) and then transfer that amount to my ROTH IRA with Vanguard. I recognize I need to pay taxes on any earnings on my contributions.
Question – Are these transfers subject to pro-rata rule? Will I be required to convert proportionate amount from my traditional pre-tax 401K account balance? My understanding was that the pro-rata rule applies only to IRAs. But this article on IRS website has confused me. It mentions pro-rata rule for any retirement plan. Perhaps I am misunderstanding.
IRS article: https://www.irs.gov/retirement-plans/ro ... ment-plans
I have read previous posts on bogleheads forum on this topic and it seems I should be ok to rollover into my ROTH IRA. But I just wanted to eliminate any concerns based on this IRS article.
Other facts – I don’t have traditional IRA account. I have ROTH IRA with Vanguard which I contribute to each year. Hence, I don’t run into pro-rata issues on backdoor ROTH conversions.

You do not need to pay taxes on the earnings in the year you roll these balances from your qualified retirement plan. You can roll the after-tax contributions to a Roth IRA and the associated earnings to a traditional IRA.

This is the pertinent section for you:

Can I roll over my after-tax contributions to a Roth IRA and the earnings on my after-tax contributions to a traditional IRA?
Yes. Earnings associated with after-tax contributions are pretax amounts in your account. Thus, after-tax contributions can be rolled over to a Roth IRA without also including earnings. Under Notice 2014-54, you may roll over pretax amounts in a distribution to a traditional IRA and, in that case, the amounts will not be included in income until distributed from the IRA.

However, this will introduce pro-rata situation for the backdoor Roth (i.e. nondeductible IRA contribution and then conversion to Roth IRA.) because it creates the traditional IRA balance. (Assuming the balance remains at 12/31.)

[scophreak]

However, this will introduce pro-rata situation for the backdoor Roth (i.e. nondeductible IRA contribution and then conversion to Roth IRA.) because it creates the traditional IRA balance. (Assuming the balance remains at 12/31.)

Clarifying for OP: the outlined strategy - after-tax contributions going to Roth IRA and earnings to Trad IRA - would indeed subject one to pro rata rule for subsequent backdoor Roth. However, this DOES NOT affect future MEGA backdoor Roth conversions, which convert directly to Roth without the intermediate stop in a Trad IRA and is not subject to a pro rata rule.

My 401k plan is strikingly similar. My strategy is to convert both after-tax contributions as well as any associated earnings to Roth and simply pay the taxes on the earnings. If you space out the 4 allowable in-service withdrawals appropriately then there are typically minimal earnings and therefore minimal tax burden (unless there are large market increases in the interim).

[worthit]

Not to hijack the thread but I have a similar plan with my employer but I have not transferred any of my contributions to date to the Roth that I have at another custodian. What is the downside to this? I was under the impression that it doesn't make a difference. Now that I think about it, it probably does as transferring to Roth would potentially enable me to avoid a large tax bill on the earnings. So it is best to transfer it right away, correct?

[RaviK]

I would like to request some help on Mega Backdoor Roth strategy and its tax implications.
My employer sponsored 401K plan allows 3 buckets – pretax, ROTH, and after-tax. It is with Vanguard. It allows up to 4 in-service withdrawals in a year. This plan does not allow in-plan conversions to ROTH. Hence, ‘in-service withdrawals’ is my only avenue to execute this strategy. My plan is to make after-tax contributions (not ROTH) and then transfer that amount to my ROTH IRA with Vanguard. I recognize I need to pay taxes on any earnings on my contributions.
Question – Are these transfers subject to pro-rata rule? Will I be required to convert proportionate amount from my traditional pre-tax 401K account balance? My understanding was that the pro-rata rule applies only to IRAs. But this article on IRS website has confused me. It mentions pro-rata rule for any retirement plan. Perhaps I am misunderstanding.
IRS article: https://www.irs.gov/retirement-plans/ro ... ment-plans
I have read previous posts on bogleheads forum on this topic and it seems I should be ok to rollover into my ROTH IRA. But I just wanted to eliminate any concerns based on this IRS article.
Other facts – I don’t have traditional IRA account. I have ROTH IRA with Vanguard which I contribute to each year. Hence, I don’t run into pro-rata issues on backdoor ROTH conversions.

What is the difference between pretax, ROTH, and after-tax? Sholdn't it be just pretax(traditional) and ROTH?

[rkhusky]

I would like to request some help on Mega Backdoor Roth strategy and its tax implications.
My employer sponsored 401K plan allows 3 buckets – pretax, ROTH, and after-tax. It is with Vanguard. It allows up to 4 in-service withdrawals in a year. This plan does not allow in-plan conversions to ROTH. Hence, ‘in-service withdrawals’ is my only avenue to execute this strategy. My plan is to make after-tax contributions (not ROTH) and then transfer that amount to my ROTH IRA with Vanguard. I recognize I need to pay taxes on any earnings on my contributions.
Question – Are these transfers subject to pro-rata rule? Will I be required to convert proportionate amount from my traditional pre-tax 401K account balance? My understanding was that the pro-rata rule applies only to IRAs. But this article on IRS website has confused me. It mentions pro-rata rule for any retirement plan. Perhaps I am misunderstanding.
IRS article: https://www.irs.gov/retirement-plans/ro ... ment-plans
I have read previous posts on bogleheads forum on this topic and it seems I should be ok to rollover into my ROTH IRA. But I just wanted to eliminate any concerns based on this IRS article.
Other facts – I don’t have traditional IRA account. I have ROTH IRA with Vanguard which I contribute to each year. Hence, I don’t run into pro-rata issues on backdoor ROTH conversions.

What is the difference between pretax, ROTH, and after-tax? Sholdn't it be just pretax(traditional) and ROTH?

Aftertax is likely nondeducted Traditional. Kind of what you do in a Backdoor Roth IRA.

[paddyj]

However, this will introduce pro-rata situation for the backdoor Roth (i.e. nondeductible IRA contribution and then conversion to Roth IRA.) because it creates the traditional IRA balance. (Assuming the balance remains at 12/31.)

Clarifying for OP: the outlined strategy - after-tax contributions going to Roth IRA and earnings to Trad IRA - would indeed subject one to pro rata rule for subsequent backdoor Roth. However, this DOES NOT affect future MEGA backdoor Roth conversions, which convert directly to Roth without the intermediate stop in a Trad IRA and is not subject to a pro rata rule.

My 401k plan is strikingly similar. My strategy is to convert both after-tax contributions as well as any associated earnings to Roth and simply pay the taxes on the earnings. If you space out the 4 allowable in-service withdrawals appropriately then there are typically minimal earnings and therefore minimal tax burden (unless there are large market increases in the interim).

Thanks everyone for the feedback. Then what does IRS mean by following:
-------------------------------

Can I roll over just the after-tax amounts in my retirement plan to a Roth IRA and leave the remainder in the plan?
No, you can’t take a distribution of only the after-tax amounts and leave the rest in the plan. Any partial distribution from the plan must include some of the pretax amounts. Notice 2014-54 doesn’t change the requirement that each plan distribution must include a proportional share of the pretax and after-tax amounts in the account. To roll over all of your after-tax contributions to a Roth IRA, you could take a full distribution (all pretax and after-tax amounts), and directly roll over:

• pretax amounts to a traditional IRA or another eligible retirement plan, and
  after-tax amounts to a Roth IRA.

----------------------------

[scophreak]

Clarifying for OP: the outlined strategy - after-tax contributions going to Roth IRA and earnings to Trad IRA - would indeed subject one to pro rata rule for subsequent backdoor Roth. However, this DOES NOT affect future MEGA backdoor Roth conversions, which convert directly to Roth without the intermediate stop in a Trad IRA and is not subject to a pro rata rule.

My 401k plan is strikingly similar. My strategy is to convert both after-tax contributions as well as any associated earnings to Roth and simply pay the taxes on the earnings. If you space out the 4 allowable in-service withdrawals appropriately then there are typically minimal earnings and therefore minimal tax burden (unless there are large market increases in the interim).

Thanks everyone for the feedback. Then what does IRS mean by following:
-------------------------------

Can I roll over just the after-tax amounts in my retirement plan to a Roth IRA and leave the remainder in the plan?
No, you can’t take a distribution of only the after-tax amounts and leave the rest in the plan. Any partial distribution from the plan must include some of the pretax amounts. Notice 2014-54 doesn’t change the requirement that each plan distribution must include a proportional share of the pretax and after-tax amounts in the account. To roll over all of your after-tax contributions to a Roth IRA, you could take a full distribution (all pretax and after-tax amounts), and directly roll over:

• pretax amounts to a traditional IRA or another eligible retirement plan, and
  after-tax amounts to a Roth IRA.

----------------------------

This means the following: you made after-tax contributions to your 401k. Unless those funds are immediately converted to Roth IRA there may be gains on the contributions. If you want to convert the after-tax contributions you must also do something with any gains on those contributions. You can either 1) roll the gains into the Roth IRA along with the after-tax contributions (and pay income tax on the gains) or 2) roll the after-tax contributions to Roth IRA and the gains on the contributions to a Trad IRA.

[neurosphere]

Thanks everyone for the feedback. Then what does IRS mean by following:
-------------------------------

Can I roll over just the after-tax amounts in my retirement plan to a Roth IRA and leave the remainder in the plan?
No...

Answered above, but let me add, indeed your quote certainly SEEMS as if the IRS is saying you must also distribute the "typical" pre-tax contributions people make to their employer plans.

But in this context "retirement plan" refers specifically to the after-tax bucket within your 401k. E.g. after-tax contributions are required to be segregated into their own account. It's as if the IRS views the pre-tax, Roth, and after-tax accounts each as a "plan" within your 401k. So when referring to a rollover/distribution of the after-tax account, its saying that pre-tax amounts (i.e. earnings, if any) must also come out of that after-tax "plan".

[retiredjg]

I have read previous posts on bogleheads forum on this topic and it seems I should be ok to rollover into my ROTH IRA. But I just wanted to eliminate any concerns based on this IRS article.

You are not the first to stumble on this article and ask this question.

The article does not mean what it seems to mean. You can roll your after-tax account to Roth IRA, leaving the remainder of your 401k as is.

[GoldenBear17]

So to be clear:

You put $1000 into your After-Tax Solo 401k account. You immediately put in a transfer to your Roth IRA. But before the transfer goes through you earn $5 in interest.

It is acceptable to transfer the full $1005 from the After-Tax Solo 401k to the Roth IRA. On your 1099-R it will show $1000 as non-taxable and $5 as taxable. You'll pay tax on the $5 for the tax year when the conversion from After-Tax to Roth IRA was completed.

Correct?

[neurosphere]

So to be clear:

You put $1000 into your After-Tax Solo 401k account. You immediately put in a transfer to your Roth IRA. But before the transfer goes through you earn $5 in interest.

It is acceptable to transfer the full $1005 from the After-Tax Solo 401k to the Roth IRA. On your 1099-R it will show $1000 as non-taxable and $5 as taxable. You'll pay tax on the $5 for the tax year when the conversion from After-Tax to Roth IRA was completed.

Correct?

Correct! And just for completeness's sake, you could also choose for that $5 to end up in a Traditional IRA instead.

[retiredjg]

So to be clear:

You put $1000 into your After-Tax Solo 401k account. You immediately put in a transfer to your Roth IRA. But before the transfer goes through you earn $5 in interest.

It is acceptable to transfer the full $1005 from the After-Tax Solo 401k to the Roth IRA. On your 1099-R it will show $1000 as non-taxable and $5 as taxable. You'll pay tax on the $5 for the tax year when the conversion from After-Tax to Roth IRA was completed.

Correct?

Correct except that few Solo 401k plans allow this. It takes a special plan.