After Tax $$$ in a 401K

Submitted by Matt Davis on Fri, 2010-09-10 14:59

I have a client whose employer 401K is invested at Vanguard. Rough numbers: he has a $1MM balance. Of that total, $80,000 is attributed to after-tax contributions with basis of $20,000. The client would like to transfer out the $20,000 (only), and leave behind all of the pre-tax $$$ (including the gains associated with the after-tax contributions). Vanguard is telling him they will not send a check for only the $20,000. Instead, they are telling him if he requests the after-tax $$$ be sent, he will receive a check for the entire $80,000 balance attributed to after-tax contributions.

From my reading of similar posts and other research I have done, it was my impression the cost basis $$$ could be transferred out separately, thus creating no taxable event and leaving 100% pre-tax $$$ that could be rolled to a rollover IRA.

1) Is this incorrect? Is it not possible to receive a check for only the cost basis of the after-tax $$$?
2) Any recommendations on how to work with Vanguard so they will process the $20,000 check as requested?

Note: I do understand the opportunity to roll the after-tax $$$ to a Roth IRA; however, the client has a need for the funds.

Thank you,
Matt



Submitted by Alan Spross on Fri, 2010-09-10 17:56

Matt,
Sounds like client is still employer there? Some plans have special provisions for non hardship in service distributions.

Even if client were separated from service, plan distributions must be pro rated between post tax and pre tax amounts. There is one exception to that. If client has pre 1987 after tax contributions, they can be distributed separately if the plan tracks them. Usually this figure shows up on plan statements.

If still employed, Vanguard’s response suggests that he has no pre 87 after tax contributions, but they allow an in service distribution of all after tax contributions and the earnings attributed to them. That would mean that 60,000 would be taxable and incur the early withdrawal penalty as well and also mandatory 20% withholding of 12,000 would apply to the pre tax portion. If he wanted to avoid any taxes, he could take the 68,000 and roll 60,000 over to an IRA within 60 days. That leaves him only 8,000 after tax until he recovers the withholding of 12,000 next spring after filing. So he gets his tax free 20,000, but has to wait another 6 months for 12,000 of it.

He could reduce any other withholding until year end and effectively make up the 12,000 sooner.



Submitted by charles lore on Sun, 2010-09-12 15:01

Alan I must say I.m a bit taken back by your response of pro rata. I’ve been away from this forum for about a yr but I do recall this issue coming up all the time. I would be the one to say pro rata end of story but you would say not so fast and give a number of other ways to go about taking out after tax money.

Has there been a resolute clarification of rules that now puts you in the pro rata camp or are you kinda throwing in the towel and to make it simple your going pro rata?

Chucl



Submitted by Alan Spross on Sun, 2010-09-12 19:04

Still no clarification from the IRS on this.
What has happened here are IRS Rev Rulings 2009-68 and 2009-75 last fall which indicated that pro rate rules would apply just as they would if there was no rollover. But this ruling created conflicts with Sec 402(c)2 of the code and several large planning organizations have been writing to the IRS ever since pleading for clarification of their ruling. We are now nearing the end of the 3rd year of direct Roth conversions from QRPs, and I can’t see the IRS forcing a redo for those who pulled off tax free conversions in 08 and 09. But there is still time to make a ruling about 2010 and inform the custodians how to complete the 1099R forms.

Here is a great article summarizing this situation by tax attorney Kaye Thomas of Fairmark. He outlines 5 strategies including the one that works for sure if you have the money to replace the 20% withholding from a direct rollover. Otherwise, you are taking a gamble that the IRS will clarify their ruling indicating that direct rollovers are subject to pro rating:

http://fairmark.com/rothira/09030801-401k-basis.htm



Submitted by Matt Davis on Mon, 2010-09-13 18:04

Alan,

Thank you for your response, guidance and link to the Fairmark article. It sounds like you agree with the conclusions in that article.

The client is still employed there and the plan allows in-service distributions after 59 1/2 or 62 (don’t recall the exact age). He is planning to retire 1/2011 and turns 64 12/2010.

The plan statement identifies the after-tax basis as post-1986 contributions so your answer now jives with the response from Vanguard.

A follow up question to your response: Is your statement true that the distribution would be subject to an early withdrawal penalty? Or were you assuming the client was not 59 1/2? Not sure I understand why it would be an early withdrawal?

My primary objective in requesting the after-tax $$$ distribution in advance of retirement and the larger distribution to a rollover IRA was to avoid having $20K basis in a $1MM rollover IRA account and having to go through the hassle of computing the pro rata taxable amount for each future distribution.

If I interpreted everything correctly from the Fairmark article, it sounds like the Strategy #3 – Single Distribution to Owner, Two Rollovers would accomplish my goal? Whether the client completes a 2nd rollover to the a Roth IRA with the remaining $8K (after FIT w/h) after-tax basis seems irrelevant in my case? In my original post, I stated the client had a use for the after-tax proceeds. In reality, it is simply that he will be going into retirement in 2011 and will need to distribute funds from his pre-tax IRAs (no other taxable accounts/cash balances to draw from), thus rolling $20K to a Roth IRA seemed like an unnecessary step if he will need those funds anyway in the short-term (though I suppose there could still be an argument to put in the $8K to a Roth IRA).

So my plan as of now would be to request the $80K check of after-tax $$$ (realizing that $12K will be mandatory 20% FIT). Then roll $60K pre-tax money to a rollover IRA. Client is left with $8K and will receive $12K FIT as a refund upon filing his 2010 1040. At retirement, is there a problem rolling the remaining balance of $920K from the 401K into the R/O IRA (just created) or is there a good reason to create a 2nd R/O IRA and keep the balances separate?

Thanks agian,
Matt



Submitted by Alan Spross on Mon, 2010-09-13 18:31

Matt,
No early withdrawal penalty if client has reached 59.5, OR if client take distributions from the plan after separation from service in the year he reached 55 or later.

Your plan will work and would avoid the slight risk that even though no conversion is planned, the IRS could rule that pro rating must apply to any direct rollover. So by doing the indirect rollover and dealing with w/h you eliminate any chance of problems. While the article deals with Roth conversion with basis, the IRS Notice 2009-75 appears to open up the pro rating problem to distributions whether there is a Roth conversion or not.

With respect to the 2011 RO of 920k, there is no reason not to roll the second larger RO into the smaller account created with the first rollover. But in the event that client already has a TIRA from regular contributions, it would be best for bankruptcy protection reasons to keep the employer rollovers separated from TIRAs containing regular IRA contributions. Under the federal BK law, there is no dollar limit of creditor protection on rollovers, while there is a limit of 1 mil on any other IRAs.



Submitted by Matt Davis on Mon, 2010-09-13 21:00

Just as an FYI:

I was on the phone with the client and Vanguard today since there had been no previous discussion of a 20% FIT withholding. The rep said the distribution request of the after-tax $$$ would be processed by sending the pre-tax $$$ to a new R/O IRA and the after-tax basis $$$ in a check to the participant, thus no required withholding.

This seems like it carries some risk based on the Fairmark article but I gather by your comment about “slight risk”, you also believe it is unlikely there would be a problem handling the after-tax distribution in this fashion? It appears Strategy 2 in the Fairmark article was addressing attempting to accomplish both a pre-tax and Roth IRA rollover vs. stopping at receiving a check for the after tax cost basis – though your response does suggest there could still be some risk of paying tax due on the rollover because of IRS Notice 2009-75.

Vanguard’s suggested process is obviously much easier. I guess I just wonder how much risk the client takes with the custodian’s recommended “easy” approach vs. receiving a check, handling the rollover themselves and dealing with the timing of the 20% tax w/h? You probably can’t answer that with 100% certainty, but to have the IRS come back and claim part of the $60K is taxable seems very punitive to the participants who believed they could rely on a well-respected custodian like Vanguard.

I understand your final point on the bankruptcy protection differences between R/O IRAs and TIRAs. Good point.

Thanks again,
Matt



Submitted by Alan Spross on Mon, 2010-09-13 21:23

You are reading my thoughts correctly, ie. there is a very small unmeasurable risk in doing the usual type direct rollover, but on balance if Vanguard will NOT change the way they have been doing their 1099R forms for years now, ie leaving Box 2a blank on the 1099R for the after tax money, I would proceed that way rather than dealing with the 20% withholding. The x factor is another IRS ruling prior to year end that would change the 1099R handling to conform to 2009-75. And several organizations have been demanding that IRS clear up the confusion, so the IRS is definitely on the spot to release something.

So if the client wants to deal with the 20% AND insists on a distribution, VG has no authority to require any rollover whatsoever. They just cut him a check for 80k (20% of pre tax amount withheld) and client takes it from there.

I wish Kaye Thomas had addressed this situation in his article because a client that does not want to roll over the entire distribution is also dragged into the 2009-75 pro rate ruling as I see it. Before direct Roth conversions came about in 2008, but following the ability to roll over the after tax money in 2002 to a TIRA, we had 6 years where custodians handled this situation the same way they did prior to 2002, simply doing a direct rollover and writing a check to the employee. And never a question.

Guess considering everything, the risk here is very small, probably less than 5%. If the IRS does make an adverse ruling, they will grandfather past and current years so both taxpayers and custodians are not thrown into chaos.



Submitted by Matt Davis on Mon, 2010-09-13 21:53

Alan,

This discussion board is a great resource for advisors. Thank you for all your timely replies.

Matt



Submitted by John Lugauer on Thu, 2013-01-31 05:08

I have a client (age 49) with $8700 loan balance who searated from service 12/3/2012.  The 401k balance at Pfizer is $157,00 of which $13,900 is after-tax basis.  The thought was to request a check for the after-tax balance and used the funds to pay off the loan prior to the March 5th, 2013 deadline.  Fidelity indicates the only distribute these funds pro-rata. Any suggestions?  Clearly I’m not interested in rolling over the 401k with the after-tax funds going into the IRA… any the client may need some additional funds given his situation.



Submitted by Alan - IRA critic on Thu, 2013-01-31 16:34

He should probably ask the plan to process an offset distribution with his direct rollover request for the remaining pre tax amount to a TIRA, and ask for the remaining after tax amount to be paid to him. That would eliminate current taxation.



Submitted by John Lugauer on Thu, 2013-01-31 17:00

I’m not sure the plan will mail the remaining after-tax amount to him because they insist the funds are only distributed pro-rata.  In the past I know they have done after tax distributions and then rolled the pre-tax to a TIRA.  Something must have changed with this plan.  How would you define the offset distribution?  Are you assuming the offset distribution would only work if they take after-tax funds and pay off the loan?  This is what we tried to accomplish yesterday.  Thanks for any help or questions we need to ask the plan.



Submitted by Alan - IRA critic on Thu, 2013-01-31 18:15

  • The plan loan specs would provide for the pre tax – post tax split for the offset distribution. Most likely, that would be pro rata, and also the same result if he paid off the balance before the lump sum distribution. I have not heard of any plans refusing to issue a check to the employee for the remaining after tax amount, but that is possible based on how the plan intreprets Notice 2009-68. If you think that perhaps you were not talking to the most informed rep yesterday or that there was a question on the order of tranactions, it might be worth it to call again.
  • I think the final distribution would include 2 1099R forms. The first would be 134,000 for a direct rollover to a TIRA of the pre tax amount, with 1099R coded G for direct rollover.
  • The other 1099R would consolidate the offset distribution exclusive of the direct rollover. The gross distribution would be 22,600 and include the taxable defaulted loan plus the 13,900 post tax amount. The taxable box 2a would show 8,700, the 20% withholding taken from the after tax balance would be 1,740, and the net check to the employee would be 12,160. That would get his basis back less the small withholding that will count toward the 2013 tax liability.
  • The following is the IRS Regs. 1.72(p)(1)  Q 15:Q–15: What withholding rules apply to plan loans?A–15: To the extent that a loan, when made, is a deemed distribution or an account balance is reduced (offset) to repay a loan, the amount includible in income is subject to withholding. If a deemed distribution of a loan or a loan repayment by benefit offset results in income at a date after the date the loan is made, withholding is required only if a transfer of cash or property (excluding employer securities) is made to the participant or beneficiary from the plan at the same time. See §§35.3405–1, f–4, and 31.3405(c)–1, Q&A–9 and Q&A–11, of this chapter for further guidance on withholding rules.


Submitted by John Lugauer on Fri, 2013-02-01 20:34

Thank you for your help.  After a follow up call today we determined a method to handle the loan payoff, after-tax dist. and pre-tax rollover:  Basically talking to a different Fidelity person was the key… as you mentioned above.The order of distributions (after-tax growth, after-tax basis…. if we rollover about $7500 to an IRA, then we can request 100% of the after-tax basis be mailed to him.  He can then pay off the loan with the after tax funds, and the remaining 401k balance is 100% pre-tax… which we can then rollover to TIRA.Why the previous rep could not help us reach this conclusion is distrubing.Thanks again.  John



Submitted by Alan - IRA critic on Fri, 2013-02-01 20:56

As long as the plan will make a partial distribution directly to him, and he then pays off the loan balance, that will eliminate the offset distribution. But I don’t understand some elements of the new proposal. It sounds like the plan included a sub account for his after tax contributions (13,900) and their earnings (evidently the approx 7,500 earmarked for a direct rollover). That is very typical, but these sub accounts generally lose their distinction at the time of separation. Since he is now separated, it seems like the pre separation distribution procedures should no longer apply. Better jump on it before they change their mind.  



Add new comment

Log in or register to post comments