Yet Another 401k -> Roth IRA Conversion Question
After reading extensively on this board and elsewhere on the internet, I was convinced that the question of whether conversion of after-tax 401k to Roth IRA was universally unsettled.
However, my employer’s benefits department claims that, after consulting with Vanguard and the IRC, section 72(d)(2) allows this conversion without basis dilution from pre-tax contributions if the custodian maintains the after-tax contributions and earnings in a ‘separate contract’ for the purpose of distribution.
Has anyone else seen this provision used (and accepted) to allow conversion of after-tax contributions and earnings directly to a Roth IRA?
Thanks!
Permalink Submitted by Alan Spross on Fri, 2010-11-12 04:39
I don’t see the “separate account” issue as a factor unless the plan limited distributions to that particular account. While I am not aware of any specific authority, it would appear to be an accounting nightmare if a plan were required to assign basis based on amounts that were not distribution eligible. In other words:
1) If the plan indicates that an in service distribution must be limited to after tax dollars and their earnings, it should not matter if they are in a separate account or not. Conversely, if there were separate accounts and the plan authorized distributions from both of them, then both would have to be considered. As long as the plan limits the distribution to this separate account, then only the funds in that account should be considered in the basis calculations.
2) Since there can be no distribution limitations after separation from service, the factors above should not be applicable to post separation distributions.
3) The tax code clearly allows pre 87 after tax contributions to come out separately if tracked by the plan. I suppose this separate tracking would be deemed a separate account. This is the only reference in the code that specifically allows separation of a class of contributions for distribution purposes.
4) I am not aware of any “ordering rules” in these plans. By that I mean if all funds are eligible to be distributed but the employee opts for a partial distribution, a plan provision indicating what character of contributions comes out before the others.
Are you referring to an “in service distribution”?
Note that the IRS is not likely to question the breakdown on the 1099R. Therefore, if Vanguard issues a 1099R showing the taxable amount in Box 2a plus the basis in Box 5 to equal the gross distribution, the IRS will accept that breakdown and assume the plan administrator is accurately reflecting the plan provisions regarding distribution of various pre tax and after tax dollars. The problem the IRS created last year was that they did not clarify why a direct rollover should be treated differently from a distribution made to the employee with respect to basis assignment.
Permalink Submitted by Sam Huffman on Fri, 2010-11-12 17:05
Thanks for the response — Sorry, yes this refers to an in-service distribution.
I have been confused, because this seems like an extraordinary benefit (allowing me to save an additional $32500 into a Roth IRA, when I otherwise couldn’t contribute to a Roth at all). It’s not clear to me why *all* 401k plans aren’t written to support this kind of benefit.
Thanks for your help!
Permalink Submitted by Alan Spross on Sat, 2010-11-13 00:17
Quite a few plans include provisions for in service distributions, mostly after 59.5, but which only include certain types of plan assets. Typically, the actual employee deferrals cannot be distributed, but employer matching and after tax contributions with their earnings can often be distributed. But plans lobbied Congress to allow the in plan conversions that were included in the Jobs Act signed in Sept. Plans wanted to retain assets that had been losing to rollovers out of the plan or Roth IRA conversions. There are unresolved questions about these in plan conversions, but they should be resolved soon. But perhaps not soon enough to complete 2010 conversions under which the taxes can be deferred for two years.