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!
