Executive Summary
While most people who contribute to a traditional 401(k) plan receive a tax deduction for their contributions, some 401(k) plans allow participants to make additional after-tax contributions over and above the deductible thresholds, up to the annual defined contribution plan limit. For those who have already maxxed out other available tax-deferred growth options, the after-tax 401(k) plan was better than nothing.
Upon retirement, though, many retirees sought to take advantage of rules that allow them to roll over their pre-tax 401(k) assets and take their after-tax contributions back, taking the two checks that the plan administrator provides them but rolling them both over – the pre-tax portion to a traditional IRA, and the after-tax to a Roth IRA in an effective tax-free Roth conversion. And the strategy only become more popular after the Pension Protection Act of 2006, which further opened the door to direct Roth conversions from 401(k) plans, and therefore the potential to directly convert “just” the after-tax check.
After years of fighting the strategy and claiming that the pro-rata rule should still apply to such conversions, the IRS has issued IRS Notice 2014-54, reversing its prior position and acquiescing to taxpayers who wish to roll over their 401(k) funds and proactively allocate their pre-tax amounts to the traditional IRA and the after-tax portion to a (tax-free) Roth conversion. While the rules are technically not applicable until 2015, the IRS has even acknowledged that it would be “reasonable” to rely on the approach now, making an open season for the strategy to split out after-tax 401(k) contributions for conversion effectively immediately.
In fact, it appears that the new IRS rules are so open in this regard, that they not only permit the free conversion of after-tax 401(k) contributions into a subsequent Roth IRA, but the availability of this conversion makes it more appealing than ever to make after-tax contributions into a 401(k) plan in the first place (at least after first obtaining the employer 401(k) match and maxxing out available pre-tax or Roth contribution limits). Will the new rules lead to a resurgence of higher-income individuals making after-tax contributions to a 401(k) plan, after maxxing out available alternatives, for the sole purpose of preparing to complete a future tax-free Roth conversion of the contributions down the road?
Understanding The 401(k) After-Tax Split Strategy For Roth Conversions
While the standard rule for contributing to a 401(k) plan is that the contributions are tax-deductible (i.e., pre-tax) going in, and taxable (as ordinary income) when withdrawn, some 401(k) plans will allow people to make non-deductible, after-tax contributions to their accounts as well. While it’s rarely ever beneficial to make an after-tax contribution instead of a pre-tax contribution (unless perhaps your tax rates are dramatically higher in retirement), for those who have maxed out on pre-tax contributions ($17,500 in 2014, plus another $5,500 as a catch-up contribution for those over age 50) the 401(k) plan may be appealing for making additional contributions above the pre-tax threshold, up to the overall annual defined contribution limit (which in 2014 is $52,000 or 100% of compensation).
Upon retirement (or otherwise leaving the company), both the pre-tax and after-tax funds can be rolled over to an IRA, retaining their original character. Thus, for instance, if someone had a $100,000 balance in their 401(k) plan that included $20,000 of after-tax contributions, upon rolling the funds over to an IRA it would still be a $100,000 account with $20,000 of after-tax contributions. When eventually withdrawn for spending purposes, the standard rules dictate that distributions are a pro-rata share of pre-tax and after-tax amounts; thus, for instance, if the retiree later takes a $15,000 distribution from this account that is 20% after-tax funds ($20,000 out of $100,000), then 20% of the distribution ($3,000) will be after-tax return of principal and only the last $12,000 will be taxable as ordinary income.
When funds are rolled out of a 401(k) plan, though, a special rule applies that allows retirees to get their after-tax contributions back immediately, and just roll over the pre-tax remainder. Under IRC Section 402(c)(2), if the retiree takes the aforementioned $100,000 account and requests to “just” roll over $80,000 and receive a $20,000 check, the tax code allows the retiree to receive the $20,000 check as all after-tax funds (with therefore no tax consequences) and claim the entire $80,000 rollover amount as pre-tax. This form of “partial rollover” strategy effectively harvests out the after-tax funds for personal use at the time of rolling out of the 401(k), while doing a pre-tax rollover of the rest, and without otherwise facing the pro-rata rule.
However, the willingness of 401(k) plan administrators to issue “two checks” – one for the pre-tax amount to be rolled over, and one for the after-tax amount to be kept – to facilitate this special partial rollover rule, has created growing confusion as some retirees sought to capitalize on the strategy by not just rolling over the pre-tax funds and keeping the after-tax remainder, but rolling over the pre-tax funds to an IRA and then rolling the after-tax to a Roth IRA as a Roth conversion – and a tax-free Roth conversion at that, since there’s no tax liability for the conversion when the funds were all after tax in the first place! Thus, an after-tax allocation that would have generated taxable growth is converted into an after-tax allocation that provides tax-free growth, at a cost of zero!
For instance, continuing the earlier example, the client with a $100,000 account balance in the 401(k) plan that included $20,000 of after-tax contributions would request two checks – one for the $80,000 pre-tax and one for the $20,000 after-tax – and then roll the $80,000 pre-tax to an IRA (which is tax-free by virtue of being a rollover) and move the $20,000 after-tax to a Roth IRA (a Roth conversion that is also tax-free because there’s no taxation on otherwise after-tax funds!). The end result – now the client has $80,000 of all pre-tax funds in an IRA, $20,000 in a Roth IRA, and the tax cost was zero!
This strategy has become even more popular in recent years, especially as the Pension Protection Act and subsequent IRS Notice 2008-30 changed the rules to allow for the first time a direct conversion from a 401(k) plan to a Roth IRA, allowing the retiree to avoid the IRC Section 408(d)(2) IRA aggregation rule and truly convert just the after-tax funds from the 401(k) plan without being forced to aggregate it with any other IRAs or retirement accounts.
IRS Notice 2009-68 And Controversy Surrounding The 401(k) Splitting Roth Conversion Strategy
While the fact that plan administrators will commonly issue two checks – one for the pre-tax amount and one for the after-tax amount – making it very easy to split the payments where one (pre-tax) goes to a rollover IRA and the other (after-tax) is converted to a Roth, such treatment is arguably not really within the intent of the original IRC Section 402(c)(2) rules in the first place. Those rules specifically address circumstances where funds are partially rolled over – and the after-tax can be kept behind – not circumstances where it is all rolled over, just to two different destination accounts (one pre-tax and one Roth).
Accordingly, after the new direct-Roth-conversion-from-401(k)-plans rules took effect, the IRS issued IRS Notice 2009-68, which affirmed that when all the funds are rolled over from a 401(k) plan, but are split across multiple destination accounts, the pro-rata rule still applies to carve up the after-tax amounts amongst the accounts. Thus, for instance, if the $100,000 account balance from the 401(k) that includes $20,000 of after-tax funds is split with $80,000 going to the rollover IRA and $20,000 going to the Roth, the IRS Notice 2009-68 guidance would require that since 20% of the funds leaving the 401(k) plan were after-tax, that 20% of each destination account is after-tax, which means the rollover IRA finishes with $64,000 of pre-tax and $16,000 of after-tax, and the Roth IRA finishes with $16,000 of pre-tax and $4,000 of after-tax… which also means the transfer of the $20,000 “after-tax check” to the Roth IRA is actually treated as $16,000 of pre-tax funds and therefore that $16,000 is reportable as income as a Roth conversion, making the strategy far less appealing! In order for the $20,000 of after-tax to retain its after-tax treatment, it would have to not be rolled over – to a traditional or Roth IRA – and instead kept outright in a bank/brokerage account; only then could the $20,000 of after-tax actually be retained separately.
Notwithstanding this IRS pronouncement – which seems in practice to have been ignored by many plan administrators, who are still issuing two checks and implying that they can be split for rollover purposes – noted IRA commentator Kaye Thomas pointed out that there are still ways that a 401(k) plan participant might still try to isolate the after-tax funds from a 401(k) plan in an effort to subsequently convert them without tax consequences, working around IRS Notice 2009-68 altogether. The most robust approach – and as discussed in the June 2009 issue of The Kitces Report, also the most complex! – is where the plan participant requests a full outright distribution of the entire account balance to themselves directly. Then, once the funds are received and deposited into a bank account, an amount equivalent to the pre-tax amounts are rolled over to an IRA, leaving only the after-tax funds behind. Then, separately (but still within the 60-day rollover period), the remainder is rolled over to a Roth IRA. This approach avoids the scope of IRS Notice 2009-68, which only covers direct rollover distributions from the 401(k) plan, and not a series of separate rollovers from a personal bank account after a distribution. The caveat to this approach, though – besides its complexity and multi-step nature with strict time windows for completion – is that when the funds are outright distributed in the first place, the standard 20% mandatory withholding rules will apply for the pre-tax amounts, which means the retiree must make up the withholding out of pocket to complete the timely pre-tax rollover (and then the remaining after-tax rollover), and recover the withholding amounts later on his/her tax return. Given the dollar amounts involved, this complication alone could potentially make the strategy impractical or outright impossible for many retirees who don’t have the available liquidity.
IRS Notice 2014-54 And The IRS Acquiesces On 401(k) After-Tax Splitting For Roth Conversions
Acknowledging both that not all plan administrators were implementing IRS Notice 2009-68 as intended – and instead were still allowing plan participants to treat the two checks as one disbursement and allocate the after-tax funds as they wished, rather than pro-rata – and also the problems highlighted by Kaye Thomas where after-tax basis in a 401(k) plan can still be isolated by the multi-step rollover approach, the IRS has issued IRS Notice 2014-54, acquiescing to taxpayer efforts to split funds and isolate basis for conversion to a Roth IRA.
Under the new rules, the IRS outright declares that in a situation where there is a direct rollover to two or more plans that are all scheduled to be made at once (such that they will all be treated as a single disbursement), “the recipient can select how the pretax amount is allocated among these plans. To make this selection, the recipient must inform the plan administrator prior to the time of the direct rollovers.”
In other words, if the 401(k) plan participant is going to receive two checks, one for $80,000 (ostensibly all pre-tax) and one for $20,000 (ostensibly all after-tax), it now really is possible to send the $80,000 pre-tax to the rollover IRA and the $20,000 after-tax directly to the Roth IRA, as long as the 401(k) owner simply notifies the 401(k) plan administrator of the plan so that the distributions can be reported appropriately. (Though the IRS does point out that the 401(k) plan may still end out issuing two versions of Form 1099-R, one for each distribution, even though they’re treated as a single disbursement for the purposes of determining how to allocate pre- and after-tax amounts amongst the receiving accounts.)
In addition, to the extent that the retiree only rolls over part of the money and really does keep the remainder outright, the IRS reaffirms the existing IRC Section 402(c)(2) treatment that the rollover is assumed to be all pre-tax (to the extent of the rollover), and the amount kept outright is assumed to be all after-tax (and any remaining pre-tax that wasn’t already part of the rollover). Thus, for instance, if $100,000 is withdrawn that includes $20,000 of after-tax and only $70,000 is rolled over (with the other $30,000 deposited into a bank account), the rollover is treated as all pre-tax, and the remaining $30,000 is treated as $20,000 of after-tax and $10,000 of the remaining pre-tax that wasn’t rolled over.
Notably, to the extent a retiree takes out only part of the account, the pro-rata rules under IRC Section 72(e)(8) do still apply to determine how much is coming out in the first place. Thus, for instance, if the 401(k) balance is $100,000 including $20,000 of after-tax funds, and the individual only requests a $20,000 distribution, then the distribution is treated as $16,000 of pre-tax and $4,000 of after-tax; while this could still be split, with the $16,000 of pre-tax to a rollover IRA and $4,000 of after-tax to a Roth, if the account owner wants to get out all $20,000 of after-tax funds into a Roth, he/she will be required to take all $100,000 from the 401(k) plan – getting out the whole $20,000 of after-tax and $80,000 of pre-tax – and can then allocate the pre-tax funds to a rollover IRA and the after-tax to a Roth.
Notably, the IRS indicates that the new allocation rules (allowing this splitting allocation of pre-tax to a traditional IRA and after-tax to a Roth) will not officially apply to distributions until January 1st of 2015. However, the IRS further acquiesces that even before the rules officially take effect, it would be “reasonable” for plan administrators to follow the existing IRS Notice 2009-68 rules (requiring pro-rata treatment) and would also be “reasonable” for the plan administrator to follow the new allocation rules even though they’re not effective yet. Furthermore, the IRS also states that it would be “reasonable” for the plan administrator to switch from the pro-rata rule to the allocation rule at the request of the plan participant receiving the funds.
Going even further in its change of views, the IRS points out that these “reasonable” interpretations apply both for distributions between now (as of September 18th when IRS Notice 2014-54 was issued) and the end of the year and for distributions that have occurred previously. This effectively provides clearance both going forward in 2015, through the end of the year in 2014, and retroactively amnesty for anyone who may have done the account-splitting approach in the past in a manner that violated IRS Notice 2009-68 but fits these new allocation rules.
The IRS notes that it plans to revise the explanation rules previously put forth in IRS Notice 2009-68 to conform to this new revised method of applying the IRC Section 402(c)(2) rollover rules.
Mega Backdoor Roth Contributions - The 401(k) After-Tax Roth Conversion Strategy
While it’s ultimately not clear whether the IRS acquiesced because their rules were fatally flawed anyway (due to the Kaye Thomas workaround) or simply because they decided it wasn’t practical or feasible to enforce the prior pro-rata guidance under IRS Notice 2009-68, the fact remains that regardless of the reason, the IRS has now opened the door for taxpayers to proactively engage in the strategy to split out after-tax 401(k) funds for a Roth conversion (and roll over the rest).
Notably, as pointed out earlier, the rules do still require that when the funds leave the 401(k) plan (before the recipient decides how to allocate them), after-tax funds are allocated pro-rata to the funds that are leaving and those that are left behind – which means in practice if the account owner wants to get all of the after-tax funds out to do a Roth conversion, they need to get all of the 401(k) plan funds out in the aggregate, if only so the full amount of the pre-tax can be rolled over to a traditional IRA while the full amount of the after-tax are converted to a Roth. If only part of the money leaves the account in the first place, only part of the after-tax funds are available for a Roth conversion. This will generally be a non-issue for those who are separating from service from the employer in the first place and eligible for a full distribution to roll over, it may limit the ability of those who are still working to fully engage the strategy unless the plan really does allow in-service distributions of the entire account.
In addition, it’s important to bear in mind that rollovers to facilitate the Roth conversion of the after-tax funds need to be balanced against other strategies that are negatively impacted by doing a rollover; for instance, losing the ability to avoid the early withdrawal penalty on 401(k) plan distributions when separating from service after age 55 (but before age 59 ½), and the opportunity to take advantage of the net unrealized appreciation (NUA) rules. Though these scenarios may not be common, they have significant potential impact for those who are eligible, and should at least be coordinated with the overall Roth conversion strategy (e.g., by waiting until after age 59 ½, or carefully considering what to convert, what to roll over, and what employer stock to distribute in-kind).
On a prospective basis, though, perhaps the most interesting aspect of the new rules allowing a standalone conversion of after-tax funds in a 401(k) plan is that it is now more appealing to make after-tax contributions to a 401(k) in the first place, in anticipation of converting them in the future! In a world where it is often difficult to isolate after-tax contributions in a retirement account for conversion, whether it’s navigating the IRA aggregation rule when trying to do a “back-door Roth contribution” or simply trying to convert an existing IRA with non-deductible contributions (perhaps after having contributed as a strategy to shelter bond interest from the new 3.8% Medicare surtax), an after-tax contribution to a 401(k) plan presents a unique opportunity to contribute now, get tax-deferred (but still taxable in the future) growth on the assets as long as the worker remains with the company (and participating in the 401(k) plan), and then the opportunity to convert those after-tax funds to produce tax-free growth after retiring (or at least after separating from service and becoming eligible for a rollover). In essence, it's a "deferred Roth contribution" strategy - a mega backdoor Roth IRA contribution where the after-tax dollars go into the 401(k) now, and get converted to a Roth IRA later.
While plans will still need to be cautious to navigate the ACP (Actual Contribution Percentage) test, where feasible the new “hierarchy” of tax-efficient savings strategies for retirement may now be:
- Obtain 401(k) match;
- Contribute further to max out pre-tax IRA and 401(k), or instead a Roth IRA and Roth 401(k) if current tax rates are low;
- Make after-tax contributions to the 401(k) plan if permitted, up to the annual defined contribution plan limits, in anticipation of converting those after-tax contributions in the future;
- Contribute to a low-cost non-qualified deferred annuity being used for tax deferral (which gets the tax-deferred growth treatment like after-tax contributions to a 401(k) plan, but not the ability to do a subsequent Roth conversion of the cost basis!)
On the other hand, it's important to recognize that President Obama did propose shutting down the strategy altogether, with a potential new provision of the tax code that would prevent any form of after-tax dollars in an IRA or 401(k) from being converted at all. This would kill the so-called backdoor Roth conversion strategy, as well as this kind of "deferred Roth contribution" strategy with after-tax dollars into a 401(k). On the other hand, at worst any after-tax dollars in a 401(k) will still grow tax-deferred (which isn't a bad deal!), and can still be used as a strategy to avoid the 3.8% Medicare surtax on net investment income!
The bottom line, though, is simply this: after years of debate, criticism of the strategy of splitting out after-tax 401(k) contributions for Roth conversion, and IRS attempts to shut down the strategy with IRS Notice 2009-68, the IRS seems to have finally thrown in the towel with IRS Notice 2014-54 and acquiesced to taxpayers engaging in the strategy, as long as the distributions happen together and the plan administrator is adequately notified of how the funds should be allocate across traditional and Roth IRAs. And this is not only good news for those who have wanted to engage in the strategy with existing accounts, but has suddenly made after-tax contributions to a 401(k) far more appealing than they have ever been in the past!
“Notably, to the extent a retiree takes out only part of the account, the pro-rata rules under IRC Section 72(e)(8) do still apply to determine how much is coming out in the first place.”
I can tell you from personal experience that some custodians allow for in-service withdrawals. When they do this, they allow you to only withdrawal the after-tax money and the earnings on the after-tax money. I don’t know if there is a distinction between the word in-service and retiree.
KyleMEaton,
I can share my personal experience that the custodian at our company allowed us to take out 100% of After Tax contributions without having to taking out 100% of before tax contributions in our 401k. They did roll over the pro-rata earnings on After Tax contributions to a Traditional IRA. I had this distribution done upon my retirement.
Hey Michael,
Thanks for another informative post . I am just curious about the earnings on the after-tax contributions. I am assuming that one would still be required to pay taxes on any earnings from the after-tax contributions portion before converting to a Roth IRA. Is this correct?
~Ross
Ross,
To the extent that any pre-tax amounts are allocated to the Roth IRA, they are taxable upon conversion. Technically it doesn’t even matter whether they were ORIGINALLY attributable to gains or pre-tax contributions, if it’s not basis it’s taxable.
In other words, in the example of $20,000 after-tax and $80,000 pre-tax, it doesn’t matter whether the $80,000 pre-tax is attribution to pre-tax CONTRIBUTIONS, the GROWTH on pre-tax contributions, or the GROWTH on after-tax contributions. Those are all in the pre-tax bucket, and to the extent anything more than $20,000 goes to the Roth (such that at least some of it is from the pre-tax bucket), it will be taxable upon conversion.
– Michael
Perfect. Thanks Michael!
Good Stuff as always, Michael! Given that the growth of the after-tax contributions may be taxable this may not be the ideal way to invest in a Roth account? This strategy would not be necessary if an employer has a 401(k) and a Roth 401(k) plan option (where the contributions and growth truly do grow tax free in the Roth 401(k)), correct? This is for employees who only have a 401(k) plan option? Thank you for always keeping us apprised of the latest!
Michelle,
The point here is about what you do AFTER you max out standard pre-tax traditional or Roth 401(k) plan option. If you want to contribute to a Roth 401(k) now, do the $17,500 to a Roth 401(k) now. THEN do MORE in after-tax contributions to the 401(k) plan for future conversions. That’s the point intended here.
It’s not an “or”, it’s an “and”.
– Michael
But what about the earnings? In the $20k/$80k example, there would have been earnings on the contributions. Are you positing that the earnings on the previously taxed $20k excess contributions accompany them into the Roth rollover to be distributed tax free at some point in the future?
Big Dog,
As far as the tax rules are concerned, the $20k of after-tax is the actual after-tax CONTRIBUTIONS. The other $80k will be some combination of pre-tax CONTRIBUTIONS, the GROWTH on the pre-tax contributions, and the GROWTH on the after-tax contributions. It doesn’t matter. All of those are “pre-tax”/taxable amounts when they come out of the account, subject to the same rules. The only amount treated as “after-tax” is literally the actual amount of after-tax CONTRIBUTION dollars themselves.
So in other words, if you put in $20k of after-tax and $30k of pre-tax (so $50k total), and with growth your account balance across all the segments doubles (so now it’s worth $100k), you still have only $20k of after-tax CONTRIBUTIONS and all the rest is in the pre-tax/taxable bucket.
– Michael
Michael,
On the IRS website it reads, “A designated Roth account is a separate account in a 401(k), 403(b) or governmental 457(b) plan that holds designated Roth contributions. The amount contributed to a designated Roth account is includible in gross income in the year of the contribution, but eligible distributions from the account (including earnings) are generally tax-free.”
This confuses me – I was also under the assumption that the earnings would go in the pre-tax bucket. Is the IRS website incorrect?
Look at the first paragraph!
http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-on-Designated-Roth-Accounts
Rob,
You’re talking about something completely different.
Nothing in this discussion has to do with a Roth 401(k), which is entirely separate and unrelated. There’s no such thing as a Roth conversion FROM a Roth 401(k), because it would already BE a Roth.
This is specifically about after-tax contributions to a TRADITIONAL 401(k) that are rolled out of the 401(k) and converted TO a ROTH IRA.
– Michael
Mike,
What do you think of Ed Slott’s take on this. He seems to feel that you can contribute and convert immediately, see here.
CONTRIBUTE & CONVERT?
Clients younger than 59 ½ can make after-tax contributions
to their plans on an ongoing basis.
Then, periodically and preferably before there are
significant gains on those amounts, they can take a distribution of those funds
and have them converted to a Roth IRA. The converted funds will be all or
mostly after-tax money, and the con- version will be virtually tax-free.
Let’s consider another worker: She is 40 years old and works
for an employer that offers a 401(k) plan allowing after-tax contributions.
Over the years, she has made a total of $140,000 of pretax salary deferrals.
Including the earnings, that sum has now grown to $290,000. She is also
eligible to make after-tax contributions, and can take a distribution of those
amounts annually. Furthermore, she is eligible to contribute$30,000 of
after-tax money to her plan. Over the
next few months, she contributes $30,000 of after-tax funds to her 401(k),
amassing a total of $33,000, including pretax earnings. Now the value of her
pretax salary deferrals and the earnings is $300,000, so her total 401(k)
balance is $333,000 of which just
$30,000 is after-tax money. She then requests a distribution from her plan.
Since she is under 59½ and still working for the company, she is unable to
access the salary deferrals and their earnings, but can tap the after-tax
contributions (and their earnings). As a result, the amount of pre- and
after-tax money she receives as part of her distribution will only be
calculated based on the $30,000 of after-tax money she has contributed, along
with the $3,000 of earnings attributable to those funds.
Now if she wants to avoid additional taxation, she can
request to have the $3,000 of pretax earnings moved directly to a traditional
IRA, while simultaneously converting her $30,000 of after-tax funds to a Roth
IRA, tax-free. She can do this once a year, supersizing her Roth IRA account.
Not all clients will have this opportunity, but for those who do, it can be a
powerful strategy.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning
contributing writer and an IRA distribution expert, professional speaker and author
of many books on IRAs. Follow him on Twitter at
@theslottreport.
Hi Mike,
Thank you for the well
explained process of using after-tax money in your 401K to fund your outside
ROTH IRA. I just want to verify that this is something we can do starting
2015 and that this is legal?
Regards,
YoungSaver
YoungSaver,
There are no legal issues here.
If your plan permits after-tax contributions, you can make after-tax contributions.
The IRS Notice permits you direct after-tax contributions to a Roth IRA as a conversion WHEN YOU TAKE ALL YOUR MONEY OUT OF YOUR 401(k) plan.
Notably, this means all you’re doing is funding a 401(k) now. You may or may not still decide to roll the money out and do a conversion to a Roth IRA later. Depending on your plan, you may be limited from doing so until you leave the company, unless the company allows you to take an in-service distribution for the entire value of the account (so you can get all the after-tax out to a Roth and direct any pre-tax to a traditional rollover IRA).
I hope that helps?
– Michael
Thanks Michael for the quick reply. My company plan does allow for after-tax contribution and keeps it in a separate account. I am not planning on leaving the company but would like to move the after-tax contribution to a Vanguard Roth IRA. Reading the article by Kaye A. Thomas
http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/
Note the importance of telling the company in advance which dollars (pre-tax or after-tax) are going to which IRA! This may seem like a trivial matter, but you haven’t followed the rules if you simply say, “Pay $30,000 to my traditional IRA and $10,000 to my Roth.” You need to say, “Pay the pre-tax dollars to my traditional IRA and the after-tax dollars to my Roth.”
It looks like I can move ONLY the after-tax contribution from my company 401K account to a Roth IRA with explicit instruction as stated in Kaye’s article. I do not want to do a full transfer just a partial transfer of the after-tax amount into my Vanguard Roth IRA. Your input would be greatly
appreciated.
Regards,
YoungSaver
YoungSaver,
Two items here:
1) If your plan doesn’t allow in-service distributions while you’re still working there, all of this is a moot point. You’ll still have to wait until you leave the company.
2) If the company does keep the after-tax contributions in a separate account, you still have to move ALL of the separate account (after-tax and pre-tax) to get the after-tax funds out, and then split them accordingly.
For instance, let’s say you have $200k in the pre-tax account, and $50k in the after-tax account, of which $40k was after-tax contributions and $10k was growth on that after-tax. You CANNOT just take out $40k after-tax. IF the plan allows in-service distributions for the full amount, you COULD take out $50k from the entire after-tax account, direct the $40k after-tax portion to a Roth IRA (as a tax-free Roth conversion) and the last $10k to a rollover IRA. (And leave the $200k in the pre-tax account behind)
I hope that helps.
– Michael
Thank you very much Michael!! The information is right on the spot of what I wanted to confirm. I will start building my Roth IRA starting this year.
Regards,
YoungSaver
My plan allows after tax 401k contributions and in-service distributions, with no limit on how many times I move the after tax contribution to an ROTH IRA.
I understand your $50k distribution to a Roth IRA ($40k)/Rollover IRA ($10k) and why one would want to roll the earnings to the Rollover IRA. But, I was told that there was a 2nd option, which would be to roll the entire $50k to a Roth IRA and have the recordkeeper generate a 1099-R for the tax on the $10k of earnings.
Since I will be doing this on a bi-weekly or monthly basis, the earnings component will not be that large, so I was thinking of doing the 2nd option. My question is, is the 2nd option a valid one?
I think when people plan to do only post tax(with associated gains), they can do so without having to pro rata the other pretax amounts if their post tax contributions and associated gains are accounted for separately… still have to pay tax on them if put into roth, or split those gains into tira, but I believe separate accounting kind of isolates some post tax sub accounts from “pro rata” of the whole 401… or i think at least it (separate accounting) allows you to take out your full post tax (basis) without having to take your full pre tax… (ie, if your post tax account has gains amounting to 10% of your pretax account, you’re not limited to rolling 10% of your post tax money, when you try to only roll you post tax sub accounts basis and gains)… someone correct me if i’m wrong.
Upon separation from service, if 50 years old employee rollovers his pre tax 401k of 80,000 into IRA account and keeps $20,000 of post tax contribution including the growth of $5,000. He was able to get two separate checks. Would he pay tax on the growth of $5k? Would he pay 10% early withdrawals penalty?
Hi Michael,
Thank you so much for the incredible post on topic and for all you continue to do for our industry.
A hypothetical situation I would like your opinion on:
A 401k plan participant has a $1mil 401k and has $100k of after-tax contributions with $200k of earnings on this $100k of after-tax contributions… this participant is under age 59.5 and the plan rules allow for an in-service rollover of $500k while the participant is still working. The distribution sequence per the 401k plan rules remove all of the after-tax contributions and the after-tax contributions associated earnings come out FIRST, and then the pre-tax contributions, pre-tax company contributions, etc. So in this example a $500k partial rollover the entire $100k of after-tax money would come out first, and the $400k pre-tax would come out second. In the current environment we have the after-tax money moved to a brokerage account and $400k pre-tax moved to an IRA. After this clarification… it *appears* we could move the $100k of after-tax contributions DIRECTLY to a Roth IRA. However, the IRS notification examples suggest the pro-rata rule applies to the $500k distribution. Meaning, of the $500k only 10%, or $50k, would be eligible to be rolled over to the Roth IRA. In this instance – it appears that the participant would be better off waiting until retirement and doing a full rollover similar to NUA to zero the 401k, and move the entire $100k to a Roth IRA. Or, are you interpretting the IRS publication as this participant could complete a partial rollover for $500k and move the full $100k after-tax to the Roth IRA?
Thank you!
Hi Michael,
Great post! Thank you for a clear explanation. If a client rolled over his 401k with after tax contributions to an IRA in 2013 is he just out of luck, or can he now recharacterize the rollover given 2014-54?
I called Schwab about a client that had already rolled w after tax and they said no re characterization was possible even though it happened just months ago. There were two checks… I will probably call again but the reason given was the 401k paperwork WAS NOT designated as Roth
KG, Thanks for that info. I will try to pursue same.
Can you clarify something in the IRS Notice, the Example 4 – employee has a $250k plan (80%pretax/20% after tax) – employee directs $80k to IRA and $20k to Roth, the $20k Roth consists entirely of after-tax. How can that happen if there wasn’t a full distribution or is it because the distributions happened together? http://www.irs.gov/pub/irs-drop/n-14-54.pdf
Joan,
Because there wasn’t a full distribution, note that the $100k that was distributed WAS pro-rata. Even though there was $50k of after-tax contributions in the plan (out of $250k total), when $100k was distributed only $20k of after-tax was associated with it. That $100k distribution with $20k of after-tax can be allocated, but the other $30k is still “stuck” inside the plan because it wasn’t a full distribution.
I hope that helps?
– Michael
Thanks, Michael. When the Notice came out I had to re-read it, as this seemed too good to be true. It sure eliminates the Code gymnastics we would go through to get after-tax money to a Roth. As I see it, based on conversations with some administrators and employers, there are a couple of hurdles – 1) does the Administrator allow for the after-tax option (as well as issuing 2 checks), and 2) will the employer get on board to amend the plan. It certainly does seem like a no-brainer. As you point out, the 415 limits really give this appeal.
The plan would have section 401(m) testing (ACP) on any after-tax contributions separate from the ADP test on the elective deferrals (regardless of whether THOSE are made traditionally as pre-tax, or as designated Roth contributions). That could be quite a deterrent.
Brian,
Thanks for pointing this out! I had meant to highlight this as a potential issue to watch for in the article and missed it in the final version. I will update accordingly!
Based on the guidance, the tax treatment of any distribution is up to the plan administrator for the remainder of 2014, correct? So it would be safest to wait until 2015 to engage in this strategy. At 1/1/2015 and following, plan administrators apparently “must” follow the direction of the 401(k) participant, such that any errors presumably would not result in adverse tax consequences to the participant.
Michael,
Thank you for another very helpful post. In your example above, what if the 401(k) participant wants to convert the $20,000 after-tax contributions to a Roth IRA but leave the $80,000 pre-tax amount in the 401(k). Would that be allowed under the new IRS guidance?
Thanks,
Steve
Hi Michael– does all this still apply under the new GOP tax plan- I noted something about no longer being able to recharacterize IRA contributions and wanted to check if there are also consequences of the new tax rules that impact (prevent?) the techniques described in this 2014 article thanks Georgia
Michal,
What about applicability of 2014-54 to IRA’s? For those high income taxpayers who have made non-deductible IRA contributions vs Roth IRA contributions, can they rollover just their non-dedeductible contributions to Roth IRA niw or do they have to do the pro-rata apportionment?
Sems like if a person can rollover his non-deductible IRA contributions to a Roth IRA (without rolling over the related earnings on the non-deductible IRA contributions) it would be a no brainer.
Kgreig,
Did you ever receive a response to your query about rolling over non-deductible IRA contributions to Roth IRA??
Michael,
What if the hierarchy of distributions (as stated in the plan document) pushes out all after-tax money first? I.e. $250k plan balance ($50k of $250k is after-tax). $100k distribution comes out $50k after-tax, $50k pre-tax. Is the participant then responsible for reporting that $30k of the after-tax is actually taxable?
Here’s Fidelity’s definition: Excess Contribution Election Also called a “spillover election,” this election, available in some plans, determines how your contributions will be handled if you reach the annual IRS maximum pre-tax contribution limit. This election allows you either (1) to suspend contributions, which means no additional employee money will be contributed to your retirement plan account on a pre-tax basis for the remainder of the year, or (2) to continue to contribute, but on an after-tax basis, if your plan allows. That means contributions to your plan may continue with “after-tax” contributions (money on which income taxes have already been calculated) for the remainder of that tax year. source link: http://wps.fidelity.com/401k/pfp/ie/defini.htm
If a plan administered by Fidelity supports excess contributions, it looks like there will be a spillover election option in the contributions page on the plan website.
I looked at the Brightscope form 5500 data for a client plan that supports Excess Contributions, and it doesn’t look like there is any indication. Has anyone figured out how to determine if a plan supports excess contributions other than reading the Summary Plan Description (SPD) or logging in and checking the contribution options?
If a employer doesn’t currently support Excess Contributions, what are the barriers to making a change?
Michael,
If a plan has allows for an in-service distribution and a participant has $20k in after-tax and $80k in pre-tax, can they elect a $20k distribution and only take out the after-tax portion? My thinking is no and that it must be pro-rata for a partial distribution. And if I am understanding correctly if they were to rollover their entire account, the earnings from the after-tax, since they are still taxable, can be rolled into a traditional IRA and only the basis from the after-tax is rolled into the Roth IRA?
Erin,
You are correct that if the participant only withdraws 20% ($20k) of the plan, they only get 20% (or $4k) of the after-tax funds.
The participant COULD then split the $4k of after-tax to a Roth conversion and the $16k of pre-tax to a Roth. But if the goal is to get out 100% of the $20k in the first place, the participant has to take 100% of the account.
– Michael
Michael, Excellent article as always. Although the splitting strategy for prior after-tax contributions seems fairly straightforward, making NEW after-tax contributions seems almost impossible. In our case, we’re an 8-person firm with a safe-harbor plan, with 3 of us maximizing our before-tax contributions. The 3 of us would now like to make after-tax contributions but our pension administrator says that there is no way we can meet the non-discrimination tests. It would be interesting to see a profile of a firm that actually passes these tests. Do you know of any? Or of any way for a smaller firm like ours to get around these tests?
Article mentions “retirees” or otherwise leaving a company, can you do this even if you do not fall into either of these categories?
DAB,
Sorry for any confusion. Technically, any eligible distribution out of the plan is eligible for the rules.
So if you’re eligible for an in-service distribution from the plan, it would follow the IRS Notice as well. Though bear in mind that the money coming OUT is on the pro-rata rule, so if you want ALL the after-tax out of the plan convert, you need to take an in-service distribution for ALL of the account value (which may or may not be possible, as some plans limit the total amount/percentage of in-service distribution).
– Michael
Can you please comment on below scenario. Let us assume I have a balance of 100. I contribute to only Pre Tax for first quarter and choose Investment A and let us assume this amount at end of year is 10. For the other quarters I only contribute Post Tax and choose Investment B which at end of the year is 20 total of 130 at year end (100+10+20). Can I at end of the year remove the amount of 20 and mark that all as Post tax since I am able to identify the specific investments it went into and can remove it with the exact amounts or will I still have to allocate the percentage of Pre and Post tax to the amount withdrawn. My plan allows me to withdraw only the post tax contributions and not any pre tax contributions. In this case even though they allow only Post tax withdrawals would I still have to for tax purposes have to split my withdrawn amounts since I am still in service.
A,
The splitting rules of IRS Notice 2014-54 have nothing to do with growth.
If your account has after-tax contributions of 10, then you can convert 10 on an after-tax basis. It doesn’t matter whether the rest of the account is 50, 100, or 500. It doesn’t matter whether the rest of the account was pre-tax contributions, pre-tax growth, or growth on the after tax. There are literally just two categories: the exact dollar amount of your after-tax contributions, and “everything else”.
And per the pro-rata rules discussed in the article, every dollar that comes out of the account is pro-rata. The only way to get out all of your after-tax is to take out EVERYTHING, and then you can split the after-tax to the Roth and the remainder to a rollover IRA.
If your plan limits the dollar amount of your withdrawal to post-tax contributions and you try to convert it, the tax code still says that was a pro-rata Roth conversion, notwithstanding what the plan originally said it was going to be. The fact that you converted it changes the taxation of it. If you want to take the after-tax and ONLY the after-tax, it has to be kept and NOT converted (as the rules are different for after-tax withdrawals you do NOT roll over or convert).
– Michael
Michael,
Thank You very much. There is still too much confusion around this and even our plan administrators did not have the proper answers. I read the tax note and then your article and that is what I was thinking would happen and did not want to risk messing up. Thanks a lot for your help. A very Happy Holidays and New Year to You.
Mr. Kitces,
Your interpretation of the pro-rata rules seem to be different than that of Fairmark (Kaye Thomas) and what has been published in Forbes magazine and Forbes online:
http://www.forbes.com/sites/ashleaebeling/2014/10/15/roth-road-to-riches/
and
http://www.forbes.com/sites/ashleaebeling/2014/10/15/aftertax-401k-rollovers-advanced-version/
http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/using-new-basis-isolation-rules/
Applying your interpretation would mean someone who takes an in-service withdrawal on the after-tax contributions (and earnings on after-tax contributions) only would pay tax on the entire distribution of after-tax dollars based on the % of pretax of the total 401k. Would this not result in double taxation on the after-tax contributions? We are talking about separately tracked after-tax contributions within the 401k account. When the after-tax contributions are distributed in retirement the basis is not taxed but the earnings are taxed as ordinary income. When the pre-tax contributions and earnings are distributed in retirement it will all be subject to taxation as ordinary income. Hence, why administrators should separately account for after-tax and pre-tax.
My 401k plan permits withdrawals of after-tax amounts prior to termination of employment. Under this scenario, can I rollover my after-tax contributions to my existing ROTH IRA? I thought I saw an articles that claimed that is possible but have misplaced that article.
Thanks–great article
This is indeed exactly what has been stated several times in recent articles written by Ashlea Ebeling with Forbes and affirmed in multiple articles at http://fairmark.com/. The contention is this is possible so long as the administrator tracks the pre-tax and after-tax contributions and earnings (within the same 401k) separately (coffee and cream are separate). I would like to understand Mr. Kitces’ position on this after he researches the articles at by Kaye Thomas at http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/.
As Kaye Thomas notes:
“Note the importance of scheduling the transfers to occur at the same time! If you make two separate transfers at different times, you don’t get the benefit of this change in the rules.”
If you JUST try to take-out a portion of the account, the amount that comes out is pro-rata, before you subsequently try to split. If you want ALL of the after-tax to convert, you have to take ALL of the account and get both transfers at once; Kaye Thomas’ writings reflect the same reality, because we’re both writing about the same IRS Notice.
Kaye Thomas covers this in the section on isolating basis:
http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/using-new-basis-isolation-rules/
My read (corroborated by Ashlea Ebeling’s reporting at Forbes), is that as long as the administrator tracks pre-tax and after-tax contributions separately (in ‘subaccounts’) the after-tax contributions AND associated earnings (pre-tax earnings associated with after-tax contributions) in the sub-account can be rolled-over simultaneously (after-tax amount into a ROTH IRA and pre-tax earnings on after-tax contributions to a traditional IRA). Again, from Kaye Thomas’ articles, and Forbes reporting, it would seem this can be performed while leaving the pre-tax contributions and associated earnings untouched in the 401k. Thoughts?
Paul,
Yes, there is a “separate accounting” rule out there for situations where the after-tax contributions (AND associated earnings) can be treated independent of the pre-tax contributions (and associated earnings). The caveat is that the plan has to truly separately account for these, which we find is rarely the case in practice.
In scenarios where separate accounting applies, the “must distribute ALL of the plan” to separate the “cream and the coffee” still applies as well, it just applies separately for each account.
For example, account includes:
$10k after-tax contributions
$5k growth on after-tax contributions
$50k of pre-tax contributions
$25k of growth on pre-tax contributions
Without separate accounting, you need to withdraw the whole $90k to split $10k after-tax to the Roth and $80k pre-tax to the rollover IRA.
With separately accounting, you still need to withdraw ALL of the after-tax contributions AND associated growth, so you end out with a $15k distribution including $10k after-tax to the Roth and $5k pre-tax to the rollover IRA. You still can’t get “just” the $10k after-tax (unless it literally has zero growth associated with it).
Again, in practice we rarely see separate accounting in use today (it seems to have been more common in the early 1980s for plans that took after-tax contributions at the time and retained the treatment since then). If it does apply, it still requires a “full distribution” of the account to convert the after-tax, but your “full distribution” may be narrowed to after-tax-contributions-plus-growth with ALL of that taken and subsequently split to different destinations.
I hope that helps a little?
– Michael
Michael,
This is very clear. Thank you. There seems to still be lots of confusion out there and arguably over-simplified reporting which I would guess have a lot of people scratching their heads. My administrator does track pre-tax and after-tax separately and distinctly so hopefully this holds up for me. I would like to be able to shift the after tax contributions & associated pre-tax earnings on those after tax contributions to ROTH & rollover IRAs at least annually and not wait until separation or retirement (in case the rules change!!). The more I can get into the ROTH the sooner, the better! If my administrator does not actually consider this separate and distinct tracking to be sub-accounts, I hope they reconfigure their accounting so it can qualify for sub-account treatment. This would be in the interest of plan participants. Perhaps you and Kaye Thomas can jointly advise large plan administrators on the sub-account treatment option (so they are aware and apply the rules consistently) and can consider changes if necessary to allow plan participants to realize the enormous benefits of maxing out after-tax contributions and moving funds/earnings to ROTH and Rollover IRAs (likely held with those same administrators) as in-service withdrawals.
Thanks again!
Michael,
You describe a “separate accounting” rule above that permits the pro-rata calculations to be made only on the after tax account (basis and earnings). Is this in the tax code? This is a very key point, and also very confusing – even the IRS guidance is not clear when describing pro-rata rules for distributions.
Background – my 401K permits in-service distributions, and they do keep pre-tax and after-tax contributions in separate accounts. So, I believe I could roll my after-tax account out of the 401K and direct the pre-tax portion to a traditional IRA and the after-tax portion to a Roth IRA. Could I also roll the entire after-tax account to a traditional IRA (this account has only nondeductible contributions)?
Hi Michael,
Does ‘separate accounting’ require actual separate account numbers? My plan provider states that the pre-tax, Roth, and after-tax nonRoth 401k contributions are in the same account, but that they keep track of all of the sources separately, and we can view the allocations in our account.
My plan allows for in-plan after-tax to Roth 401k rollovers, as well as in-service withdrawals before age 59 1/2 with no limits to the frequency. They stated that :
“When requesting an In-Plan Roth Rollover/Transfer in your Symantec
Corporation Section 401(k) Plan, you may specify sources; therefore, you
are no required to request a pro-rata rollover or transfer from all of
the sources.
When requesting an in-service withdrawal before age 59 1/2 (not a
distribution/withdrawal after separation of service) only certain
sources qualify for the withdrawal. You may select to withdraw only the
after-tax contributions and earnings.”
I’d like to rollover after-tax non Roth contributions to Roth 401k or Roth IRA on a regular basis if the pro-rata rule doesn’t apply…
Thanks!
Michael,
Regarding the after tax rollover from a 401k while the participant is active. If the balance is 500k and of that after tax if 50k. Say there is an in-service withdraw available that will include 50k after tax and 50k of pretax. The participant chooses to roll 50k to pretax and the 50k of after tax to a Roth IRA. In your opinion, how do you feel like the IRS will treat this transaction? My understanding is that only 10k would move to the Roth with no tax liability and 40k would be treated as taxable through the conversion process. The other 50k would easily move into the rollover IRA in the pretax format. Is this accurate? What are your thoughts on how that may conflict with that of the plan’s withdrawal guidelines?
Thanks,
Guest #401
Guest,
Your conclusion about the application of the pro-rata rule is correct.
All else being equal, recent IRS guidance trumps outdated plan administrator withdrawal guidelines.
Notably, if the funds are NOT rolled over and the individual KEEPS the $50k of after-tax, it really IS possible to keep the $50k after-tax and just roll over the $50k of pre-tax. It’s the decision to roll it all over – some to traditional, some to Roth as a conversion – that triggers these rules and makes the pro-rata treatment apply.
Obviously (and sadly), conforming to the rules will be a bit ‘messy’ until plan administrators get their plans updated to the recent guidance.
– Michael
I’m being told by a client that their 401K plan’s administrator has told them that employees can elect to take an inservice withdrawal of only the post tax contributions and roll those directly to a ROTH IRA. The company in question is a financial sevices firm with no testing issues and the majority of employees make enough to contribute the maximum pre & post tax amounts each year. Thus, if this is indeed allowable, it would be a great planing techique. It seems to me however that this disregards the rules in place for partial distributions being treated proportionatly. Can you please comment?
I have a 401(k) with my former employer with both pre-tax and after-tax contributions. I will be rolling over the pre-tax portion into a 457(b) with my current employer. Can I rollover the after-tax portion into a Roth 457(b)? My current employer says no. How about into a Roth IRA? Provide a reference if possible. Thanks.
I have a similar situation as Eliot. I have a 401k with my former employer that has both pre-tax and after-tax contributions. I would like to roll over 100% of it…mostly to simplify my life. I’d like to move the pre-tax portion to my current employers plan (TSP, which is basically a 401k plan) and the after-tax contributions to an existing Roth IRA (Vanguard). Is this possible? Everything I read talks about the pre-tax portion being rolled into a traditional IRA, but can it be rolled into my TSP instead or does it have to go to a traditional IRA? Thanks!
You can roll over the pre-tax portion to any retirement account that accepts rollovers. It doesn’t have to be an IRA, it can be another pre-tax employer retirement plan. However, it’s worth noting that not all employer retirement plans allow roll-ins, so an IRA often ends out the recipient by default.
– Michael
In a case where there is 100% distribution of 401K due to separation of service, all pre-tax (including earnings on after-tax contribuitons) goes to IRA directly. Plan administrator will not send the after-tax contributions to the new Custodian but instead issues a check to the client. The client, I’m assuming can roll those $ over to a Roth within 60 days. Correct? What if the client only wants to rollover a portion? Also, same client (under 59 1/2) also utilizes NUA. The 10% penalty on the cost basis of the stock is eliminated if the client is over 55 when separating from service, correct? Or, is there a separate rule about the penalty for NUA if you’re under 59 1/2? Thank you!
Clarifying the last post, I am referring to the client only rolling over a portion of the after-tax contributions to a Roth and keeping the balance in the bank. 100% of the 401K is leaving the plan. Thanks!
Michael, if you’re self-employed, LLC, and have a solo 401k, can you create a separate 401k account that is just for nondeductible contributions? Then convert the funds in the nondeductible account either to a 401k Roth or Roth IRA (is it either or, or is one of them preferable)? And can you do convert only the nondeductible contribution without withdrawing deductible funds from the regular 401k at the same time? And finally, can you do the conversion almost immediately (no profit generated in say a few days)?
Thanks.
Thanks so much for this informative article. I see one question that is the same as mine (by Can), but I don’t see an answer. My husband is 62 1/2. We had to do a 3-way split on his 401k because there were some self-directed stocks we didn’t want to sell, so a portion of the 401k is still with the company. (Minimal percentages of the after-tax and pre-tax had to stay with the original 401k to enable us to keep our self-directed stocks). Of what we took out, the taxable portion is in the process of being directly rolled over into a Traditional IRA with a new administrator. The tax-free portion was sent to us via check with the intention of converting it to a ROTH IRA with the same new administrator (within 60 days). My question: We would like to keep about $2500 of that check in the bank, and fund the ROTH with the remainder. Is there a problem with that? Will that negate the “conversion” since the amount would be different?
Sue,
This is not an issue at all. Because all of the check is after-tax anyway, whatever you keep will be non-taxable, and whatever you put in the Roth IRA will be non-taxable. It’s your choice about how much to convert versus just keep. There’s no obligation to convert; it’s simply whatever you DO convert BY placing into the Roth IRA will be tax-free going forward.
– Michael
Thanks Michael! Just what I was hoping to hear.
Michael, a client retired and instructed the whole 401k account to be rolled over, custodian is issuing 2 checks, the taxable portion FBO to new IRA custodian and after tax portion to client. Can client now take that after tax check and deposit to ROTH as an after thought even tho he told administrator to just cut check for after tax money?
Another fantastic article that answered detailed lingering questions that I couldn’t even find mention of, let alone answers for, anywhere else on the web. Since you brought up the fact that NUA (Net Unrealized Appreciation) will complicate matters … it turns out that this is exactly my situation. Am I correct in thinking that because all of the stock for NUA is after-tax, it really shouldn’t complicate things all that much? What it sounds like to me is that I will be asking the administrator to liquidate the 401k with three output streams: 1= all after-tax money rolls into a Roth IRA (and thanks by the way for the excellent explanation that only after-tax CONTRIBUTIONS are considered after-tax; all earnings are still pre-tax simply because they haven’t been taxed yet), 2= Instead of rolling all pre-tax funds into a traditional IRA, split that into 2a= take delivery of the stock for the NUA strategy (paying taxes on it either from a portion of the Roth money, or, preferably, from savings outside of the 401k), and 2b = All of the rest of the pre-tax funds roll into an IRA. Or am I missing something obvious (or not-so-obvious but mandated by other IRS rules)?
If I take after tax contributions from my 401k to a roth ira would I have to wait 5 years before taking out w/ds tax free if I am under 59.5?
Mike,
My employer allows after tax 401K plan and allows in service withdrawal from the 401K every 6 months. The strategy I am thinking is to max out the after tax 401K and convert it into ROTH IRA every 6 months. The gains made in that after tax account can be rolled over to the traditional IRA. My employer, merryl lynch (my 401K) holder and Meryl edge my roth IRA holder said , it is perfectly fine with no tax liability. Can you please advise and see any IRS issues with this scenario?
Many thanks, Mr. Kitces, for your numerous lucid posts!
We recently established our small company’s new retirement plan with Vanguard. After reading about the Roth super-funding possibility, we specifically enabled options for 401(k), Roth 401(k), and after-tax (non-Roth) deferrals. Although our plan allows for employer matching and profit sharing contributions, both are discretionary and we don’t expect any such contributions this year.
We have one under-50 non-HCE who has maxed out his Roth 401(k) deferrals at $18,000. He would now like to make up to $35,000 in after-tax contributions as the year progresses. Yet at least four separate Vanguard representatives have told us that all employee contributions are capped at $18,000, and that the only the employer can fill the region between $18,000 and $53,000 (via matching and profit sharing). It seems our employee can’t use the Roth super-funding strategy. Is this correct?
Michael:
Thank you for your in-depth analysis, as always.
Can this feature be used with a solo 401k plan? It can’t “fail” ACP or ADP test if there is only one employee, can it?
Thanks,
Michael,
Does IRS 2014-54 still apply to this strategy or have tax regs changed since this was written? I’ve got client interested in max funding to $54K defined contribution limit.
Many thanks,
Gary
Gary,
No further changes/guidance. This is still the latest.
Though notably President Obama’s last budget proposal did include a crackdown to end this going forward. See https://qa.kitces.com/blog/treasury-greenbook-fy2017-presidents-budget-proposals-target-crackdown-retirement-and-estate-planning-loopholes/. But it was never enacted. No word whether the current administration is also eyeing a crackdown or not.
– Michael
I really appreciate the quick follow up. This is a great topic that is VERY helpful to a current client I have. Many thanks!
My plan allows after tax 401k contributions and in-service distributions, with no limit on how many times I move the after tax contribution to an ROTH IRA.
I understand that with a large $50k distribution to a Roth IRA ($40k)/Rollover IRA ($10k in earnings) and why one would want to roll the earnings to the Rollover IRA. But, I was told that there was a 2nd option, which would be to roll the entire $50k to a Roth IRA and have the recordkeeper generate a 1099-R for the tax on the $10k of earnings.
Since I will be doing this on a bi-weekly or monthly basis, the earnings component will not be that large, so I was thinking of doing the 2nd option. My question is, is the 2nd option a valid one?
Question I cannot find an answer to. What if a 401(k) plan allows for in-service distributions on some of the money in the plan and not other monies? Does the pro-rata rule apply? For example, let’s say a plan allows for in-service distributions at any age, for any reason, on all after-tax contributions. And let’s say you are 40 years old and you only have pre-tax contributions and after-tax contributions in your account. Can you remove 100% of the after-tax contributions directly into a Roth and avoid pro-rata rule? The only reason I think this might be possible is because the pre-tax funds are not accessible at the time. Thanks.
Michael,
If I’d like to move funds in the opposite direction, consolidating retirement money inside a 401K, how would that work if I have Traditional and Roth IRAs to rollover. The Traditional IRA contains both pre-tax and after-tax contributions. How could I roll those over to 401K? Can the Roth IRA be rolled over to a Deemed IRA within the 401k? Can after-tax tradtional IRA be rolled over to 401k either after-tax or Roth subaccount?
Thanks!
Sam
Keep Good Records. I contributed $1,800 to a post tax 401K in 2008, it grew to $2,700 by 2015. In 2015,
I performed an in service rollover from my present 401k, to a IRA it included both Pretax and Post tax balances. The Post tax portion I deposited to a Roth IRA.
Two years later, the IRS sent me a bill for $2,200 for underpayment of taxes, penalties, interest and negligence penalties. I spent several hours gathering paperwork showing them that money was from Post tax contributions and earnings. The plan administrators didn’t provide me with any specific data other than two 1099Rs one pretax and one post tax. The Post tax 1099R has a box which was checked stating that $0 was taxable on the $2700, yet the IRS wanted to tax me on it.
Two months later they accepted my documentation stating that it was not taxable. Fortunately I had a pay stub from 2008 showing my post tax contribution.
If you have contributed after-tax money into your 401k, and if you are still working for the same employer at age 59 1/2, and if your plan allows for withdrawals while still working, is there any reason not to rollover the after-tax contributions into a Roth IRA immediately upon reaching age 59 1/2? Wouldn’t future gains made on the after-tax contributions be tax-free if the after-tax contributions were rolled over into a Roth IRA, but eventually be taxable if the after-tax contributions were left in the 401k?