Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis, of course!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at two questions related to the increasingly popular strategy of making after-tax contributions to a 401(k) plan and subsequently converting them to a Roth, either via an intra-plan conversion to a Roth 401(k), or using ongoing in-service distributions from the 401(k) to convert to a Roth IRA!
Intra-Plan 401(k) Conversions To A Roth 401(k) ("Designated Roth Account")
Question/Comment: Our company just added in-plan Roth 401k conversions to our plan, as well as allowing after-tax contributions to the Traditional 401k. Question is - do you think the pro rata rule applies when you do an in-plan Roth conversion, or can you isolate the after-tax money in the Traditional 401(k) when converting to the Roth 401k? All the writing we've found only addresses the IRS ruling last fall re: moving after-tax money to a Roth IRA. My gut tells me the pro rata rule applies to in-plan conversions to a Roth 401k, but I can find that anywhere. Any thoughts?
The Small Business Jobs Act of 2010 created IRC Section 402A(c)(4), which stipulated that a distribution from a 401(k) plan can be rolled over to a designated Roth account (i.e., a “Roth 401(k)” plan), in what now is often called an “intra-plan Roth conversion” transaction.
As a Roth conversion, the funds that are transferred from the 401(k) to the Roth 401(k) are not subject to any early withdrawal penalties. However, IRC Section 402A(c)(4)(A)(i) is explicit in stating that the conversion is still a distribution that is taxable, to the extent it otherwise would be.
And because it’s still treated as a “distribution”, indeed that means the guidance of IRS Notice 2014-54 about distributions that include after-tax contributions out of a 401(k) plan still applies, so the distribution is subject to the pro-rata rule here.
In other words, this may be an intra-plan conversion to a Roth 401(k) and not to a Roth IRA, but it’s still a distribution being converted, so the same pro-rata tax treatment applies to the money that is leaving the original traditional 401(k) account. In fact, the guidance under IRS Notice 2010-84 explicitly states in Q&A-7 that “the taxable amount of an in-plan Roth rollover is the amount that would be includible in a participant’s gross income if the rollover were made to a Roth IRA.” Which means, again, that the pro-rata rule will apply here to an intra-plan Roth conversion, too.
Notably, though, the IRA aggregation rule will not apply to an intra-plan Roth conversion, as the aggregation rule specifically is only for IRAs; in the case of employer retirement plans, you’ll calculate that pro-rata distribution amount based only on the retirement plan account balance (and after-tax contributions) for that employer. If the client does multiple intra-plan conversions over time (as new contributions are made), each conversion will be still subject to the pro-rata rule, based on the total value and total after-tax contributions of that plan at that time.
Notably, under the expanded intra-plan Roth conversion rules from the Small Business Jobs Act and IRS Notice 2010-84, the same outcomes would apply for an intra-plan 403(b) or 457(b) conversion as well. On the other hand, it’s important to remember that an intra-plan Roth conversion is only permitted if the employer retirement plan offers a designated Roth account and specifically allows conversions – though fortunately, it sounds like your plan has already taken that step!
Ongoing Roth Conversions Of In-Service Distributions From A 401(k) Plan To A Roth IRA
Question/Comment: How do the Roth conversion rules work for in-service distributions of after-tax 401(k) contributions? Our company allows for in-service distributions, but only of after-tax contributions... could I theoretically max out my 401(k) pretax, and then make say $30-$40k in after-tax contributions, and then do an in-service of just the after-tax to a Roth IRA?
The new rules of IRS Notice 2014-54 issued last fall regarding the Roth conversion treatment of 401(k) plans that include after-tax contributions apply to any distribution from a 401(k) plan, whether it is an in-service distribution or one that occurs after retirement/separation from service.
So the good news is that yes, it absolutely is possible to do the favorable after-tax-to-Roth splitting treatment for in-service 401(k) distributions under that guidance – presuming, of course, that the plan allows in-service distributions in the first place (which it doesn’t necessarily have to do).
However, the “bad” news is that the plan does need to comply with the guidance in IRS Notice 2014-54, which means it still is not possible to distribute only the after-tax contributions for Roth conversion. Per the IRS’ latest guidance, any/all distributions must be done on a pro-rata basis as the funds leave the plan if a Roth conversion is occurring, which means if you try to take just some of the account balance, you only get some of the after-tax contributions!
Example 1. A 401(k) plan includes $50,000 of after-tax contributions and a total balance of $250,000. If the plan participant takes a $50,000 in-service distribution, under IRS Notice 2014-54, a distribution from a plan that was 20% after-tax ($50k out of $250k) means the distribution will be treated as 20% after-tax, so the $50,000 will be $10,000 of after-tax and $40,000 of pre-tax. Once that distribution occurs, you can send the $10,000 of after-tax to a Roth (as a tax-free conversion of basis) and the $40,000 to a traditional rollover IRA.
Notably in the above example, trying to take just the after-tax funds means you only get $10,000 of the after-tax out. If you want all $50,000 of after-tax (100%) out of the plan, you have to take all (100%) of the plan’s account balance in the first place (which may or may not even be possible as an in-service distribution, depending on the details of the plan and its flexibility for in-service distributions). Notably, there is an old rule under IRC Section 402(c)(2) that allows just the after-tax to be taken out first, but that applies only if the funds are not rolled over or converted (i.e., they land in your checking/investment account, not in an IRA or Roth RIA); if you roll over or convert, the pro-rata rule of IRS Notice 2014-54 applies.
Now, one partial exception to this rule is that if the plan separately accounts for the after-tax contributions and associated growth, it is possible to distribute and roll over just the after-tax and its associated growth but not the rest of the plan. In this case, the pro-rata rule would only apply to the separate accounting share.
Example 2. Continuing the prior example, assume that the $50,000 of after-tax contributions also has $40,000 of (pre-tax) growth associated with it (for a total value of $90,000), which are separately accounted for from the remaining $160,000 in the 401(k) (which includes $80,000 of pre-tax contributions and $80,000 of pre-tax growth). In this situation, if the plan participant takes $50,000 from the after-tax share, it still won’t be a pure $50,000 of after-tax, but it will be treated as being 55.6% after-tax ($50,000 out of $90,000), which means $27,778 will be after-tax and only $22,222 will be taxable in the Roth conversion (or alternatively, the $27,778 can be sent to the Roth on a tax-free basis and the $22,222 can be rolled over to a traditional IRA to avoid any tax consequences, but it still means not all the after-tax came out of the plan at once).
In the above example, separate accounting still requires the pro-rata rule to apply, but only to the after-tax and its associated growth. So the $50,000 distribution is now $27,778 after-tax, instead of only $10,000 after-tax in the prior example. And the plan participant could get all of the $50,000 of after-tax out by withdrawing “just” the $90,000 in the after-tax account (including contributions plus growth) while leaving the remaining $160,000 behind.
Notably, if a plan separately accounts, this also means that on an annual/ongoing basis, you could contribute to the after-tax portion of the account every year, and then do a Roth conversion out every year. To the extent that the money is the account for only part of the year, there will likely be little-to-no growth in the account, so it would at least be almost entirely just an after-tax conversion each year. It would basically be a kind of “supercharged” backdoor Roth contribution, though as with other backdoor Roth contributions, it’s probably still a good idea to let the contribution ‘season’ in the account for a while, rather than trying to contribute and immediately convert. If the plan does not separately account, you could still do this strategy, but you will be subject to the pro-rata rule based on the entire account when each conversion distribution occurs (which may be fine if the plan allows you to withdraw the whole account as an in-service distribution, but if not you’ll be stuck just ‘dribbling’ out the conversions of after-tax over a period of time, with the remainder converted all at once when you separate from service).
I hope that helps a little!