Qualified plan and Roth Conversion
There may not be a definitive answer to this question, but after reading Slott Report Mailbag for 8/6/2009 (question #3 says yes to same situation) and looking at the various discussion forum quesions/answers, I am really confused. My situation is this:
Retired individual has a 401K plan with $350,000 pre-tax dollars and $100,000 after-tax dollars. Prior to 2010, individual was not eligible to do a Roth conversion because of income constraints. Plan administrator will not distribute one type of dollars without distributing the other–i.e., it’s an all or nothing deal. If you want to take a distribution of the after-tax money, you have to take a distribution of pre-tax money as well. Individual wants to do a direct rollover of 100% pre-tax dollars to a traditional IRA and a direct rollover of 100% after-tax money to a Roth IRA. The administrator will do this transaction as two separate checks. However, is this individual subject to the pro-rata rules for Roth conversions? The individuals has no other traditional IRA’s.
Permalink Submitted by Alan Spross on Thu, 2010-02-04 03:01
You are correct, there is no specific IRS ruling that covers this particular scenario using direct rollovers, although there are plenty of opinions. The plan custodians also do not have specific guidelines in the 1099R Inst on how to report these transactions either, and that will result in a lack of consistency from one plan to another.
Conversely, there is little doubt that this can be accomplished using an indirect rollover, but an indirect rollover will trigger the 20% mandatory withholding on the pre tax amount. However, if the employee can front the withholding the tax code is clear that since the first dollars the employee rolls over are deemed to be pre tax, the employee could roll the pre tax amount to a TIRA, and then roll the after tax amount to a Roth IRA. This wording is in Sec 402(c), since 2002.
The problem is that there is no clear rule under which the same rules will apply to direct rollovers, even if the plan administrator does the direct rollovers in the same order. Lacking that clarity, the pro rate rules come into play making for a pro rating of after tax money for rollovers to each type of IRA account, and this is not what you want.
While an employee that is fortunate enough to get the type of 1099R they are looking for, the chances of the IRS questioning their return are greatly diminished. The danger is that the IRS will finally clarify the situation in a way that forces revision of this year’s 1099R forms.
So, what to do now? With someone who has considerable basis in their plan as in your example, the best choices are:
1) Do the rollover by indirect rollover if they can replace the withholding. This could also be done with a partial distribution if replacing the withholding is not possible with a full distribution.
2) Or – wait awhile until this issue is cleared up by the IRS.
If you want a copy of the 402(c) wording referred to above, please advise.
Permalink Submitted by Linda Taylor on Fri, 2010-02-05 16:30
I have a similar situation. I have no money in IRA accounts of any type but I have retired and have my 401k account at my former employer. I have $15,000 in after-tax contributions and $150,000 in pre-tax contributions in the 401k. The plan does not allow for partial distributions, only a full distribution. Plan administrator is Fidelity. I have opened a Roth account and Traditional IRA account at Vanguard in anticipation of transferring the funds. Fidelity will cut two checks – one for the $15,000 and one for the $150,000 so that I can convert the $15k to the Roth and the $150k to the TIRA. Are you saying that I will not know until receipt of the 1099R after the end of the year whether Fidelity will report the $15,000 as not being taxable in the conversion? If that is the case, is it possible to find someone at Fidelity now who could tell me how they would intend to report the transaction?
Thank you!
Permalink Submitted by Linda Taylor on Fri, 2010-02-05 16:31
One more thing – I cannot replace the 20% withholding on an indirect rollover, so that is not an option.
Permalink Submitted by Alan Spross on Fri, 2010-02-05 23:17
OK, that takes the indirect rollover option off the table, and the plan requirement for a full LSD takes partial indirect rollovers off the table as well.
Therefore, it is probably best to wait a short time to see if the IRS clarifies if there is a way to segment the pre tax funds to a TIRA and the after tax funds to a Roth IRA using direct rollovers.
Pro rating does not mean that the 15,000 would become taxable, what it means is that the pro rate factor is about .909 pre tax meaning that .909 of each IRA type would be pre tax funds. That would result in only 1,364 of the Roth conversion being tax free and 13,636 taxable. The traditional IRA would then receive the other 13,636 of after tax funds to go with the 136,364 of pre tax funds.
Even if Fidelity tells you now if they would code the 1099R on a pro rated basis, or assign all the after tax amount to the Roth IRA, there is a major risk that an IRS Notice will not allow them to do that and they will be forced to change their procedures and their 2009 and 2010 1099R. Another option is to go ahead with the conversion, and if things do not work out, you can still recharacterize as much of the conversion as you wish.
Of course, if you wanted to convert the entire amount, the pro rating issue would disappear altogether. Then you would just be taxed on the 150,000 pre tax portion, and you could split that between 2011 and 2012.
Permalink Submitted by Linda Taylor on Sat, 2010-02-06 00:29
Thank you very, very much for your reply. I really appreciate the assistance, especially the reminder that I could recharacterize.
Permalink Submitted by Jim Bachman on Sun, 2010-05-16 15:43
Alan:
If I understand your “indirect rollover option”, it would be like this.
Say I have $300K in a 401K of which $100K is after-tax contributions and $200K is pre-tax contributions + earnings.
I first do a distribution of the $200K, triggering the administrator to distribute $160K to me and withhold $40K (20%). This partial distribution is deemed to be pre-tax money.
I then send $200K to my TIRA (the $160K from the 401K + $40K which I front) — this has to be done within 60 days or the distribution.
This leaves $100K in the 401K which is deemed to be the after-tax contributions.
In a second step, I roll this to a ROTH.
When I file my return I get my $40K back as a refund.
Is this how you mean?
Does the second rollover need to be indirect or can it be a direct roll to the ROTH?
Can I move all the pre-tax and all the earnings (including earnings on post-tax contributions) in the first step?
Thanks
Permalink Submitted by Alan Spross on Mon, 2010-05-17 00:53
Not exactly. The indirect rollover option would executed as follows:
1) Ask for a FULL distribution from the plan. You would receive 260k and 40k would be withheld as the mandatory 20% of the pre tax amount.
2) Roll over 200k to a TIRA
3) A couple days later roll the remaining 60k along with 40k you will have to come up with to the Roth IRA.
2 and 3 must be done within 60 days of receipt of the funds. You will recover the 40k as you said when you file your return. The total distribution described above will be tax free.
The difference from your post is that there is only one rollover from the plan, not 2.
Permalink Submitted by Jim Bachman on Mon, 2010-05-17 21:24
Thanks. How does this get around the language in pub 590 (p62)?
“Any amount rolled over is subject to the same rules for
converting a traditional IRA into a Roth IRA.”
in reference to rolling part or all of a distribution from a qualified plan to a ROTH IRA.
Is there another source you are basing your suggested approach on?
rgds,
Jim
Permalink Submitted by Alan Spross on Tue, 2010-05-18 00:07
Yes, see Sec 402(c) copied below. Note that this paragraph speficies distributions paid TO THE EMPLOYEE as opposed to a direct rollover. When the employee then completes the indirect rollover, the order is the pre tax amount is deemed rolled over first:
>>>>>>>>>>>>>>>
c) Rules applicable to rollovers from exempt trusts
(1) Exclusion from income
If –
(A) any portion of the balance to the credit of an employee in a qualified trust is paid to the employee in an eligible rollover distribution,
(B) the distributee transfers any portion of the property received in such distribution to an eligible retirement plan, and
(C) in the case of a distribution of property other than money, the amount so transferred consists of the property distributed, then such distribution (to the extent so transferred) shall not be includible in gross income for the taxable year in which paid.
(2) Maximum amount which may be rolled over
In the case of any eligible rollover distribution, the maximum amount transferred to which paragraph (1) applies shall not exceed the portion of such distribution which is includible in gross income (determined without regard to paragraph (1)). The preceding sentence shall not apply to such distribution to the extent –
(A) such portion is transferred in a direct trustee-to-trustee transfer to a qualified trust which is part of a plan which is a defined contribution plan and which agrees to separately account for amounts so transferred, including separately accounting for the portion of such distribution which is includible in gross income and the portion of such distribution which is not so includible, or
(B) such portion is transferred to an eligible retirement plan described in clause (i) or (ii) of paragraph (8)(B). In the case of a transfer described in subparagraph (A) or (B), the amount transferred shall be treated as consisting first of the portion of such distribution that is includible in gross income (determined without regard to paragraph (1)).
>>>>>>>>>>>>>>>
Permalink Submitted by Jim Bachman on Tue, 2010-05-18 13:50
I keep reading this over and over. Doesn’t the very last sentence say that direct rollovers (done in part) come first from pre-tax? I am still struggling with how to interpret the citation as supporting indirect only. I have to admit that I cannot understand exactly what paragraph 2 means.
Permalink Submitted by Alan Spross on Tue, 2010-05-18 22:47
Yes, the code section gets worse every time you reread it!
It commingles the max amount that can be rolled over, how much can be excluded from income and further breaks it down between QRPs and IRAs. The IRA part is the last paragraph (2)(B). Note that (i) and (ii) of 8B are IRAs and IRA annuities respectively.
You can ignore (2)(A) where direct T to T transfers are referenced because that paragraph only covers QRP to QRP transfers.
(2)(B) for IRAs makes no reference to DIRECT transfers and this is where it states that rollovers from QRPs to IRAs are considered to move the pre tax amounts first. Also note that P 2 relates back to P 1 where “paid to the employee” is referenced in (A).
Hope this helps, but the wording is very cumbersome.