As more and more baby boomers retire, an increasingly popular strategy is to split pre- and after-tax funds in a 401(k) at retirement, with the goal of rolling over the pre-tax funds into an IRA, and converting the after-tax funds into a Roth IRA, taking advantage of the non-taxable nature of the after-tax contributions.
Yet the effectiveness of the strategy is ambiguous at best; recent guidance from IRS Notice 2009-68 would suggest that the approach shouldn't be allowed at all, and although some esoteric and technical workarounds have been suggested, none have truly been tested or subjected to IRS scrutiny. As a result, while many 401(k) plans are willing to issue separate checks to accommodate those who wish to try the strategy, and the odds of getting caught are low, caution is still merited about whether the client will really end out with the desired tax treatment.
The inspiration for today's blog post is a series of inquiries I've received in recent months about the strategy of splitting pre- and after-tax 401(k) distributions, with the goal of completing a Roth conversion for the after-tax amount, while sending the pre-tax amount for an IRA. For example:
Sherry has a $100,000 401(k) that includes $20,000 of after-tax contributions. Her goal is to move the $20,000 of after-tax contributions to a Roth IRA as a tax-free Roth conversion (since after-tax funds are not taxable when withdrawn or converted), and the remaining $80,000 to a rollover IRA. In the end, the $20,000 Roth IRA will grow tax-free, and the $80,000 rollover IRA will be taxable in the future. Sherry intends to accomplish this by asking the employer to distribute the 401(k) in two checks: one for the after-tax amounts, which she will roll over to a Roth IRA (by having the check made payable directly to the Roth IRA as a trustee-to-trustee transfer), and the other check for the remaining (pre-tax) amounts which she will roll to her traditional IRA.
If the accounts grow until they double, then in the future Sherry will have $40,000 of tax-free Roth funds, and $160,000 of taxable IRA investments. This is much better than the alternative, to simply roll over all $100,000 of the 401(k) to an IRA, which would result (after enough growth to double the account) in a $200,000 future IRA with $20,000 of non-deductible contributions, leaving Sherry with $180,000 of future taxable withdrawals. In the end, with the Roth conversion strategy Sherry has $160,000 of future taxable IRA growth, while with the "normal" rollover strategy, she has $180,000 of taxable IRA growth. Therefore, Sherry has saved $20,000 of future IRA taxable income, and the current tax cost was "nothing" since converting after-tax amounts to a Roth generates no current tax liability!
Under IRC Section 402(a), distributions from employer retirement plans generally follow the rules of IRC Section 72 (or specifically, IRC Section 72(e)(8)), which states (with respect to qualified plans) that taxable distributions will be treated as including a pro-rata share of any "investment in the contract" (i.e., cost basis, or after-tax contributions).
If Sherry were to distribute $50,000, then 20% (or $10,000) of it would be non-taxable, because 20% of her total account ($20,000 / $100,000) is non-taxable.
In addition, under the Pension Protection Act of 2006, IRC Section 408A(c)(3)(B) was modified to provide that individuals can complete a Roth conversion directly from a 401(k) plan to a Roth IRA, without being required to first roll over the money to a traditional IRA for subsequent conversion (which would also cause the funds to become subject to the IRC Section 408(d) IRA aggregation rule, along with all other IRAs, when calculating the tax consequences of the conversion).
In the case of a rollover (including one that is converted to a Roth IRA), though, a slightly different set of ordering rules apply than the standard pro-rata rule, under IRC Section 402(c). Previously, most experts interpreted the somewhat complex provisions of 402(c) to indicate that when a rollover distribution from a 401(k) occurs, it is treated as coming first from the pre-tax portions of the account, and once all pre-tax amounts have been rolled over, any remaining rollovers are attributable to after-tax funds.
However, recent guidance from IRS Notice 2009-68 suggests a different treatment. Under IRS Notice 2009-68, Sherry must treat her IRA rollover as receiving a pro-rata share of the after-tax portion of the funds, and the Roth IRA conversion would in turn also receive a pro-rata share. Accordingly, if Sherry sent $80,000 to the rollover IRA and $20,000 to the Roth IRA, then the rollover IRA would include $16,000 of the basis (80% of the basis, since it was 80% of the rollover), and the Roth IRA would only be allocated $4,000 - which means in turn that the $20,000 sent to the Roth IRA will be taxable as a Roth conversion for the last $16,000.
On the other hand, the IRS Notice 2009-68 guidance does affirm that if Sherry receives a full distribution of the 401(k) plan (for which 20% mandatory withholding would also apply), then any rollovers that occur would be treated as coming from pre-tax amounts first, and after-tax amounts second. However, this treatment appears to only apply as long as Sherry keeps a portion of the funds. In other words, if Sherry receives a full $100,000 distribution, the first $80,000 of any rollover would be treated as pre-tax amounts first, and Sherry would be left with an after-tax balance of $20,000. Unfortunately, if Sherry then tries to convert the remaining $20,000 of after-tax funds to a Roth IRA within 60 days, the entire distribution will have been rolled over (since it would all have to occur within the same 60-day rollover period), which means the pro-rata rules apply once again!
Disagreements Still Abound
Notwithstanding the guidance of IRS Notice 2009-68, disagreements still abound regarding whether this strategy is possible. The two most commonly cited counterpoints are a letter from the American Benefits Council, published in response to IRS Notice 2009-68 and objecting to certain parts of it, and a discussion by noted IRA commentator Kaye Thomas about isolating basis from a 401(k) to complete a Roth conversion.
The letter from the American Benefits Council is essentially a position statement from the organization to the IRS, regarding the rollover rules under IRC Section 402(c)(2), suggesting that the organization believes the IRS' interpretation of IRC Section 402(c)(2) is incorrect, on the grounds that it is not an effective means of tax and retirement policy, that the guidance itself is incomplete and can lead to unusually problematic rollover situations, and that it is not consistent with the historical evolution of IRA rollover rules. In addition, the organization simply questions the IRS' interpretation outright as being different than their own reading and interpretation of IRC Section 402(c)(2). Notably, though, while the American Benefits Council may disagree with the IRS, the reality is that the IRS has not changed its position at this time.
On the other hand, the article by Kaye Thomas suggests, in essence, that the IRS' guidance itself is still ambiguous about a particular form of the rollover strategy, and advocates that it could be interpreted favorably on behalf of the taxpayer (or at the least, doesn't appear to be in direct contravention to the IRS' position in IRS Notice 2009-68). Thomas suggests a strategy which has actually been advocated by many IRA experts for a long time (and was previously discussed in the June 2009 issue of The Kitces Report as well), which is a multi-step process to completing a rollover. This "conservative" approach suggested that as a first step, the retirement plan would make an outright distribution to the participant. Once the plan has been fully liquidated in a distribution to the participant, he/she rolls over an amount equal to the pre-tax value to an IRA, and then subsequently and "separately" rolls over the remainder of the distribution to a Roth IRA. The amounts that should be allocated to pre-tax money were rolled over first to ensure the proper application of the ordering rules under IRC Section 402(c)(2). The remainder, which would theoretically only be after-tax funds at that point, simply needed to be rolled over to a Roth IRA (completing the conversion) before the normal 60-day deadline that applies to rollovers. The most significant caveat to this approach was simply that if the plan participant receives a full outright distribution, the mandatory 20% withholding rules will apply. Thus, to follow this approach, the client would be need to make up the missing 20% of the distribution out of pocket to complete the pre-tax rollover, then roll over (as a conversion) the remaining after-tax funds to the Roth IRA, and finally recover the 20% "excess" withholding when the tax return is filed early in the subsequent year. Depending on the size of the 401(k) account and the client's available liquidity, having funds available for the 20% withholding might have been problematic, but otherwise the strategy was presumed to be sound.
Strictly speaking, the IRS' guidance under IRS Notice 2009-68 is still not definitively clear on the tax consequences of the final step - the rollover of the remaining presumed-to-be-after-tax funds to the Roth IRA as a conversion. It is clear, under the IRS' guidance itself, that when a distribution occurs and only part of the amount is rolled over, that the rollover will be pre-tax funds under IRC Section 402(c)(2) and that the remainder in the client's account will be the after-tax funds. However, this assumes that the remaining (after-tax) amounts stay in the client's taxable account. In Thomas' opinion, this should also mean that a subsequent rollover of the remaining funds must be after-tax only, since the IRS already said (indirectly) that the preceding rollover was all the pre-tax funds; in other words, "what else is left" at that point to convert but an after-tax remainder?
So what is wrong with this approach? The criticism of the Thomas approach (and in light of the IRS' overall scrutiny of such transactions) is the idea that doing a rollover of the pre-tax funds and a subsequent rollover of the after-tax funds may still, in the end, be treated as a single rollover. After all, there was only one distribution, and the rules of 402(c)(2) are ultimately meant to describe the tax consequences of a single distribution, not of a multiple rollover transaction. In other words, perhaps the fact that both rollovers occurred within the 60-day period and pertained to a single distribution means, in the end, they're equivalent to a single rollover, especially if the IRS chooses to apply the step transaction doctrine to treat them as a single taxable event. Unfortunately, though, if the transaction is treated as a single rollover, then the end result is that once again cost basis must be allocated pro-rata amongst all of the destinations of the single rollover; the attempt to split funds would be foiled once again.
In the end, there is still truly no guidance to definitively support the various approaches advocated to split pre-tax and after-tax dollars from a 401(k), with the goal of rolling over the pre-tax amounts and converting the after-tax amounts, although the weight of the evidence from the IRS suggests that they believe it should not be possible (not the least of which, because they issued IRS Notice 2009-68 in the first place to attempt to 'clarify' the issue, even though some gray areas remain).
Accordingly, the two articles described here - the letter from American Benefits Council and the article by Kaye Thomas - are inconclusive at best. In point of fact, the American Benefits Council letter simply articulates a series of points on which the organization disagrees with the IRS. It does not change the fact that the IRS has published guidance, and what that guidance itself says. The organization is simply pointing out that they believe the IRS' perspective is incorrect, and asks the IRS to change it to something that they believe is better reflective of good tax and retirement policy (and in their view, a 'more accurate and reasonable' interpretation of the tax code itself). The Thomas article, on the other hand, points out what is ultimately still a somewhat gray and ambiguous area about a particular form of the distribute-and-rollover strategy to utilize IRC Section 402(c)(2), but still is not ultimately definitive or "safe" to execute. At best, it provides the grounds by which a client could object to the IRS if challenged; it does not necessarily mean the client will be deemed correct by the IRS or the courts in the end. It is hard to even estimate a likelihood that the client would prevail; however, from a practical perspective, it seems likely that the IRS would at least try to challenge the position if discovered, as the Service is trying hard to cut down on perceived abuses and loopholes regarding Roth conversions. On the other hand, it may still be difficult for the IRS to discover taxpayers who utilize the strategy in the first place, so it is similarly true that while the risk of challenge is high, the risk of discovery to even be challenged in the first place is low (a similar plight applies to the so-called "Backdoor Roth IRA contribution").
To say the least, this means that clients who are interested in such a strategy should be cautioned that there is still significant ambiguity and some risk. In addition, it's notable that the mere fact a 401(k) provider is "willing" to issue two checks is not a basis for avoiding pro-rata treatment; the administrative implementation of a distribution is not legal guidance about the tax treatment! Although some practitioners have suggested that clients may as well "go for it" since they can always recharacterize the conversion later if the tax consequences are unfavorable, it is notable that this may not be an option if the IRS does not challenge until after the recharacterization deadline (i.e., the statute of limitations for the IRS to question the transaction lasts far longer than the time horizon a client can recharacterize a Roth conversion). In the end, some clients may indeed still wish to "go for it," but should at least be unaware that the path is highly uncertain at best, and at worst is directly contradicting the IRS' own position on the issue.
The more conservative approach would be to simply take the IRS' guidance at face value - given the "clarification" of IRS Notice 2009-68 - that it is not possible to split the pre-tax and after-tax funds from a 401(k) for the purposes of rolling the pre-tax amount to a traditional IRA and converting the after-tax remainder. Of course, this does not necessarily mean it is bad to complete a Roth conversion of a 401(k). In point of fact, the new rules allowing direct conversion of 401(k) plans to Roth IRAs are still appealing, as the direct conversion at least ensures that the client can use all of the after-tax funds within the 401(k) and is not required to aggregate other IRAs when calculating a pro-rata share of after-tax funds. But it is still a pro-rata distribution.
So what do you think? Have you tried the 401(k) splitting strategy? Would you counsel a client to do so? Are the benefits in the end really worth the risk?