What to do with after-tax 401k money

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madbrain
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What to do with after-tax 401k money

Post by madbrain »

I have been contributing after-tax money to my former employer's 401k. The employer allowed in-service withdrawals/rollover once a year.

This january, I withdrew all the after-tax contributions and associated earnings from last year, and rolled them over to a Roth IRA at Vanguard. So far, so good.

Last month, I got terminated from the company. I had already maxed out the my $49k of 401k contributions for the year including about $30k of after-tax money.

I just talked to JP Morgan and they said I can no longer withdraw and rollover just the after-tax contributions like I did in january. The terms of the plan for withdrawals after termination are different. They said all withdrawals would be prorated. Since I have about $300k total in the 401k, the after-tax money represents 10%. In order to withdraw the $30k of after-tax money, I would have to withdraw the whole account balance ! If I withdrew $10k, only $1k of it would be pre-tax money. etc. With penalties and tax, needless to say, I don't want to do that.

I wanted to leave all the pre-tax and matching money in the 401k plan as it is a very good plan, but rollover the after-tax money to my Roth, so that the earnings would never be taxed. But it doesn't sound like this is possible now.

The rep said I could rollover the funds to another plan, either 401k or traditional IRA. My new employer's 401k doesn't accept after-tax funds, so I don't think this is an option. What would happen if I went with the traditional IRA option ? I am afraid I would run into the same prorating issue when trying to rollover the after-tax funds to my Roth.

I don't currently have any traditional IRA, only the Roth (and all its money comes from prior conversions of non-deductible traditional IRA contributions and after-tax 401k contribution rollover).

It looks like the best option is to leave all the funds in the old 401k plan alone. But then the earnings on my after-tax money will become taxable when I withdraw them in retirement, and they wouldn't be if rolled over into a Roth.

What would you do ? Are there any other options I'm missing ?
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interplanetjanet
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Re: What to do with after-tax 401k money

Post by interplanetjanet »

madbrain wrote:I have been contributing after-tax money to my former employer's 401k. The employer allowed in-service withdrawals/rollover once a year.
...
The rep said I could rollover the funds to another plan, either 401k or traditional IRA. My new employer's 401k doesn't accept after-tax funds, so I don't think this is an option. What would happen if I went with the traditional IRA option ? I am afraid I would run into the same prorating issue when trying to rollover the after-tax funds to my Roth.
I'll take a wild stab at this.

It's normal (and required by law) for 401k plans to not take after-tax rollover money. This can work to your advantage for the purpose of isolating the before and after tax portions of your old 401k. What I would suggest would be to do something like this:

1. Roll your entire old 401k into a rollover IRA. Take note of how much is pre and posttax.
2. Roll the pretax portion of this IRA into your new 401k (pro-rata rules do not apply as 401k's can only accept pretax rollovers by definition).
3. Roll the remaining posttax portion in the IRA into a Roth IRA.

This leaves you with only pretax money in a 401k, the posttax money in a Roth, and nothing left in a Traditional IRA so you can do backdoor Roths going forward if you want.

-janet
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madbrain
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Re: What to do with after-tax 401k money

Post by madbrain »

interplanetjanet wrote: 1. Roll your entire old 401k into a rollover IRA. Take note of how much is pre and posttax.
2. Roll the pretax portion of this IRA into your new 401k (pro-rata rules do not apply as 401k's can only accept pretax rollovers by definition).
3. Roll the remaining posttax portion in the IRA into a Roth IRA.

This leaves you with only pretax money in a 401k, the posttax money in a Roth, and nothing left in a Traditional IRA so you can do backdoor Roths going forward if you want.

-janet
Thanks for the quick reply. This sounds OK. I just wonder about the logistics of steps 1 and 2. Seems to me that the rollover IRA custodian would have to take note of the pretax/posttax amounts as well before I could get a check that can be rolled over to a 401k.
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Re: What to do with after-tax 401k money

Post by interplanetjanet »

madbrain wrote:
interplanetjanet wrote: 1. Roll your entire old 401k into a rollover IRA. Take note of how much is pre and posttax.
2. Roll the pretax portion of this IRA into your new 401k (pro-rata rules do not apply as 401k's can only accept pretax rollovers by definition).
3. Roll the remaining posttax portion in the IRA into a Roth IRA.

This leaves you with only pretax money in a 401k, the posttax money in a Roth, and nothing left in a Traditional IRA so you can do backdoor Roths going forward if you want.

-janet
Thanks for the quick reply. This sounds OK. I just wonder about the logistics of steps 1 and 2. Seems to me that the rollover IRA custodian would have to take note of the pretax/posttax amounts as well before I could get a check that can be rolled over to a 401k.
Any one company can't track the percent of any rollover that will be pre vs post tax - remember that as far as the IRS is concerned you have one IRA, even if it's split up amongst many separate IRA accounts. You are responsible for tracking this yourself.

Keep good records. :)

-janet
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Post by interplanetjanet »

This probably goes into it in more and better detail than I can:

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

-janet
Alan S.
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Post by Alan S. »

You didn't indicate whether your new employer will accept IRA rollovers or not. That is key to one of the methods of isolating your basis as janet indicated. Check that out. If the new plan will accept incoming IRA rollovers, you could do the direct rollover of your former plan balance to a TIRA, then roll the pre tax amount to the new plan and lastly convert the after tax basis remaining in the TIRA. You would report the after tax contribution and the conversion on an 8606.

While it would not derail this plan, your 2011 tax return would be easier if you did not get a 1099R from the old plan combining the January after tax rollover with the final lump sum distribution. It might cause issues with that January transaction depending on how the plan completed the 1099R. Putting this off till 2012 would eliminate those risks.

Finally, if your new plan will NOT accept the IRA rollover, you could take a look at Fairmark's Strategy 3. Under that strategy you can isolate your basis, but must come up with the 20% withholding temporarily and that figure appears to be $54,000 (20% of the pre tax amount of 270,000). If you cannot handle that, you could consider doing this piecemeal each year. Distributing 20% each year would reduce the single withholding bill to 10,800, and you would just complete strategy 3 at the rate of 20% each year. This would also be a different 1099R from the January transfer IF you did the January transfer as a direct rollover. You could start this year if that were the case, but if you took an actual distribution last January, then the commingled issues mentioned above would still apply.
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Post by scrabbler1 »

When I left my company in 2008, I had some after-tax contributions in my 401(k) along with a much larger amount of pretax contributions and earnings on both the pretax and after-tax contributions.

What I did was to do a direct rollover from all the tax-advantaged dollars (the latter described above) into a traditional IRA. This made the tax bite zero, of course. I took the after-tax contributions (not the earnings on them) as cash which was also a non-taxable event. I could have rolled it into a Roth but I needed the cash for other reasons. This was the only chance I had to completely and cleanly separate the after-tax contributions from their earnings so I was not going to let it slide.

I also had a large amount company stock which I took out as NUA which kept its tax bite low, but that's another story.
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Post by interplanetjanet »

scrabbler1 wrote:What I did was to do a direct rollover from all the tax-advantaged dollars (the latter described above) into a traditional IRA. This made the tax bite zero, of course.
Can you tell me how you did this rollover without being subject to the usual pro-rata rules? It's my understanding that the IRS requires the following:

"Any distribution from a retirement plan account in which there is basis is treated as consisting of both pre-tax amounts (your employer's pre-tax contributions and earnings) and your after-tax contributions."

The reason that rolling into a 401k "works" to isolate basis and rolling into a TIRA does not is that TIRAs can accept basis in rollovers, while 401k's cannot.

-janet
scrabbler1
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Post by scrabbler1 »

interplanetjanet wrote:
scrabbler1 wrote:What I did was to do a direct rollover from all the tax-advantaged dollars (the latter described above) into a traditional IRA. This made the tax bite zero, of course.
Can you tell me how you did this rollover without being subject to the usual pro-rata rules? It's my understanding that the IRS requires the following:

"Any distribution from a retirement plan account in which there is basis is treated as consisting of both pre-tax amounts (your employer's pre-tax contributions and earnings) and your after-tax contributions."

The reason that rolling into a 401k "works" to isolate basis and rolling into a TIRA does not is that TIRAs can accept basis in rollovers, while 401k's cannot.

-janet
This was not a distribution, which I agree would be subject to the pro-rata rules had it been one. It was a Direct Rollover into a TIRA.

On the many forms my company gave me when I gave instructions to our Plan Administrator as to how to take the 401(k)'s proceeds, there was a question I had to answer as to if the receiver of the proceeds (my IRA holder) would accept after-tax contributions via Direct Rollover. I checked the "NO" box and added additional instructions that I wanted to take those after-tax contributions in cash (via direct deposit, if possible, which they did).
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Post by interplanetjanet »

scrabbler1 wrote:This was not a distribution, which I agree would be subject to the pro-rata rules had it been one. It was a Direct Rollover into a TIRA.
In this context, distribution refers both to withdrawals and to "rollover distributions" - rollovers are normally done pro-rata as well.
On the many forms my company gave me when I gave instructions to our Plan Administrator as to how to take the 401(k)'s proceeds, there was a question I had to answer as to if the receiver of the proceeds (my IRA holder) would accept after-tax contributions via Direct Rollover. I checked the "NO" box and added additional instructions that I wanted to take those after-tax contributions in cash (via direct deposit, if possible, which they did).
Interesting. TIRAs normally do accept after-tax contributions.

-janet
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Post by scrabbler1 »

Janet, I took a look at the 1099-R form I received to see how it described the after-tax contributions. They were reported in Box 5, described as "Employee contributions/designated Roth contributions or insurance premiums." These contributions were made back in the mid-1990s under Rule 401(a). Rule 401(a) was simply the after-tax version of 401(k) which today sounds a lot like a Roth 401(k).

A second 1099-R form showed the total amount of the Direct Rollover in Box 1 with the taxable amount of zero in Box 2. I had no taxes withheld so I did not have to file either form although I did attach a statement to my return describing the various amounts and combining them together. This was back in 2009 for my 2008 return and I have not been questioned on it.

I still contend that a Direct Rollover is not a distribution so there was no problem totally separating the after-tax contributions from the pretax earnings. The forms I described in my earlier post have been used for several years so if there was a problem then the Plan Administrator would have changed them.
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Post by Alan S. »

Actually, janet's question is a very good one. This is where IRS Notice 2009-68 and 2009-75 conflict with prior the prior practices in issuing 1099R forms by plan administrators. There are plenty of questions how those Notices affect "isolation of basis" strategies for doing Roth conversions with only the post tax money, but rarely does anyone ask how the pro rate rules were avoided in the many years prior to those Notices.

The IRS never questioned the old practice of doing a direct rollover of the pre tax amount and cutting a check to the employee for the after tax amounts in the past. The gray area resides in Sec 402(c)2 of the code that indicates that distributions to the employee that are rolled over are composed first of the pre tax balance. But the pre tax balance was not distributed to the employee, it was directly rolled to an IRA in a transaction that is reported as a distribution on Form 1040. Therefore, the gray area is whether this pre tax rollover is considered made to the employee or not. If not, it brings into question how pro rating was avoided in all those prior years where people cashed out the after tax balance. All this confusion continues because the IRS has never issued clear 1099R instructions to employers but continues to honor the old style 1099Rs being issued to this day. The American Benefits Council has sent several letters to the IRS begging for clarification over the last 2 years, but has received no response. Probably because the IRS has opened Pandoras box here and does not know how to close it.
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Post by madbrain »

Janet,
interplanetjanet wrote:This probably goes into it in more and better detail than I can:

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

-janet
Thanks, lots of useful info there !
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madbrain
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Post by madbrain »

Alan,
Alan S. wrote:You didn't indicate whether your new employer will accept IRA rollovers or not.
I just checked the plan documents - yes, it will.
While it would not derail this plan, your 2011 tax return would be easier if you did not get a 1099R from the old plan combining the January after tax rollover with the final lump sum distribution. It might cause issues with that January transaction depending on how the plan completed the 1099R. Putting this off till 2012 would eliminate those risks.
Agreed. My 2011 return will be complicated enough.
I also had a backdoor IRA conversion in february .
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Re:

Post by madbrain »

Alan,
Alan S. wrote:You didn't indicate whether your new employer will accept IRA rollovers or not.
While it would not derail this plan, your 2011 tax return would be easier if you did not get a 1099R from the old plan combining the January after tax rollover with the final lump sum distribution. It might cause issues with that January transaction depending on how the plan completed the 1099R. Putting this off till 2012 would eliminate those risks.
So, it is January now. I called Vanguard (custodian for my IRAs) about the rollover on Wednesday, and they got JP Morgan (custodian for my 401k) on the line for a conference call. I requested a direct rollover to Vanguard. The JP Morgan rep said I would receive two checks - one for the pre-tax money (salary deferrals and matches), and another for the after-tax money, both made to Vanguard. The idea is that the first check will be rolled over to my Traditional IRA at Vanguard, and the second check to my Roth IRA, also at Vanguard. Both reps believed that this would not be a taxable event. As of the first of this year, my balance and basis in traditional IRAs is $0.

I haven't gotten the two checks yet but expect them very soon. I have yet to see the exact amounts, in particular, whether the second check is only for the after-tax contribution amount, or whether it also contains the earnings attributable to those contributions. In the later case I would assume some tax would be due on them.
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Re: What to do with after-tax 401k money

Post by jebmke »

madbrain wrote:So, it is January now. I called Vanguard (custodian for my IRAs) about the rollover on Wednesday, and they got JP Morgan (custodian for my 401k) on the line for a conference call. I requested a direct rollover to Vanguard. The JP Morgan rep said I would receive two checks - one for the pre-tax money (salary deferrals and matches), and another for the after-tax money, both made to Vanguard.
I have a similar issue (pre-tax and after-tax money in 401(k) plan. Due to the issues raised by Alan's earlier post, I have held off while I sort out how to do this. I have been advised to take the distribution all in December paid to me (less withholding tax) and then deposit the gross amounts separately to ROTH and TIRA rather than do direct rollover. This would me that I have to float the withholding tax for about 3 months.

It seems to me that you won't know for sure if this works until you get past the three year audit cycle. You are still going to get one 1099 with a code of "G" in Box 7, right? When you file your taxes, there will be no distinction between the ROTH and the TIRA in terms of destination of the money.
When you discover that you are riding a dead horse, the best strategy is to dismount.
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madbrain
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Re: What to do with after-tax 401k money

Post by madbrain »

jebmke,
jebmke wrote: It seems to me that you won't know for sure if this works until you get past the three year audit cycle.
I suppose that would be true of any uncertain tax issue, though.
You are still going to get one 1099 with a code of "G" in Box 7, right? When you file your taxes, there will be no distinction between the ROTH and the TIRA in terms of destination of the money.
I have no idea what the 1099 will say.
I did a rollover of after-tax contributions last year from my 401k to my Roth IRA already - but that time it was an in-service withdrawal. But I don't have the 1099 for that yet.
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Re: Re:

Post by interplanetjanet »

madbrain wrote:So, it is January now. I called Vanguard (custodian for my IRAs) about the rollover on Wednesday, and they got JP Morgan (custodian for my 401k) on the line for a conference call. I requested a direct rollover to Vanguard. The JP Morgan rep said I would receive two checks - one for the pre-tax money (salary deferrals and matches), and another for the after-tax money, both made to Vanguard. The idea is that the first check will be rolled over to my Traditional IRA at Vanguard, and the second check to my Roth IRA, also at Vanguard. Both reps believed that this would not be a taxable event. As of the first of this year, my balance and basis in traditional IRAs is $0.
I believe that this separation of IRA "basis" into a Roth account through multiple distributions (one per rollover), while a common event, is still potentially murky. You are basically using "Strategy 2" of the Fairmark article I mentioned earlier ("split distribution"). As I understand it, the IRS hasn't gone after people for this but in some of the statements it has made, it has effectively reserved the right to.

That said, having already started this I might just let it ride. The chance of it becoming an issue is small.

-janet
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Re: Re:

Post by madbrain »

Janet,
interplanetjanet wrote: I believe that this separation of IRA "basis" into a Roth account through multiple distributions (one per rollover), while a common event, is still potentially murky. You are basically using "Strategy 2" of the Fairmark article I mentioned earlier ("split distribution").
I think this is slightly different from method 2 in the Fairmark article. In the article, method 2 has the withdrawal split to two different recipients - one rollover to the IRA, and another to the 401k account holder, who then rolls it over to the Roth. In my case, I am getting two separate checks, but they are both made to the same recipient - Vanguard. So, I think this is a different method, not mentioned in the Fairmark article.
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Re: What to do with after-tax 401k money

Post by jebmke »

madbrain wrote:jebmke,
jebmke wrote: It seems to me that you won't know for sure if this works until you get past the three year audit cycle.
I suppose that would be true of any uncertain tax issue, though.
Yes, if there is ambiguity in the code and/or no settle cases to clarify. The problem with this one is that, as I understand it, there is little in the history to point to what the IRS will do if a case comes up.
When you discover that you are riding a dead horse, the best strategy is to dismount.
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Re: What to do with after-tax 401k money

Post by Default User BR »

I've just always been a bit concerned about the two rollover method. I feel safer with the combined rollover to an IRA, and rolling back the taxable portion to a qualified plan. Note that some have raised questions about that method as well, but I think the IRS pubs support it, and they'd have a hard time in tax court on that basis.

Further note that you need a cooperating qualified plan. For those without a plan or one that doesn't take rollovers from IRAs, that's a problem. A possible solution is a self-employment of some sort with a solo 401(k) that can accept the rollover. That is a lot of hassle to make this happen.


Brian
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Re: Re:

Post by madbrain »

madbrain wrote: I haven't gotten the two checks yet but expect them very soon. I have yet to see the exact amounts, in particular, whether the second check is only for the after-tax contribution amount, or whether it also contains the earnings attributable to those contributions. In the later case I would assume some tax would be due on them.
I got them today. One check is for the exact amount of my after-tax contributions last year on my last payroll, ie. no earnings.
There is a stub with two lines - one stating Total Rollover Distribution, and the other After-tax portion of Rollover , in the same amount.

The second check has the same stub with different amounts with the after-tax portion of the rollover listed as zero.
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Re:

Post by madbrain »

scrabbler1 wrote:Janet, I took a look at the 1099-R form I received to see how it described the after-tax contributions. They were reported in Box 5, described as "Employee contributions/designated Roth contributions or insurance premiums." These contributions were made back in the mid-1990s under Rule 401(a). Rule 401(a) was simply the after-tax version of 401(k) which today sounds a lot like a Roth 401(k).

A second 1099-R form showed the total amount of the Direct Rollover in Box 1 with the taxable amount of zero in Box 2. I had no taxes withheld so I did not have to file either form although I did attach a statement to my return describing the various amounts and combining them together. This was back in 2009 for my 2008 return and I have not been questioned on it.

I still contend that a Direct Rollover is not a distribution so there was no problem totally separating the after-tax contributions from the pretax earnings. The forms I described in my earlier post have been used for several years so if there was a problem then the Plan Administrator would have changed them.
I got my 1099-R for tax year 2011 . I made an in-service rollover in january 2011 of my 2010 after-tax contributions to a Roth IRA.
JP Morgan forced me to get earnings out at the same time.

The 1099-R from JP Morgan shows the total distribution in box 1.
In box 5, it shows the amount of my 2010 after-tax contributions.
The box 1 amount is higher. So, I have to pay tax on the difference, which is the earnings which I'm converting to Roth.

However, for the withdrawal I just made in 2012, as an ex-employee, I got two checks, and the second one was for the exact amount of my 2011 after-tax contributions without any earnings. So I expect not to have to pay any tax on this 2012 rollover. The rules of my former 401k plan are different for in-service withdrawals than for former employees. The in-service withdrawals are less favorable.
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Re: Re:

Post by Default User BR »

madbrain wrote:However, for the withdrawal I just made in 2012, as an ex-employee, I got two checks, and the second one was for the exact amount of my 2011 after-tax contributions without any earnings. So I expect not to have to pay any tax on this 2012 rollover. The rules of my former 401k plan are different for in-service withdrawals than for former employees. The in-service withdrawals are less favorable.
Who is the second made out to? It's not that clear that you can split the contributions off to a Roth tax-free in this situation.



Brian
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Re: Re:

Post by madbrain »

Default User BR wrote: Who is the second made out to? It's not that clear that you can split the contributions off to a Roth tax-free in this situation.
Brian
Both checks were made to Vanguard FBO me.
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