Isolating 401k Basis for a Conversion
An awkward but effective strategy
By Kaye A. Thomas
Posted March 8, 2009
For those who want to move after-tax dollars from a 401k to a Roth.
If you have after-tax dollars in your 401k account, those dollars will reduce the amount of income you'll report when you draw down the account. That's good, but any investment earnings produced by those dollars between now and the time you take out your money will be taxable. You'd do better if you could move those after-tax dollars to a Roth account, so any subsequent investment earnings will be tax-free, assuming you follow all the rules.
You can't do anything about that situation unless you're in a position to withdraw your money from the 401k account. Most people can't do that while they're still working for the company that maintains the plan. Once you can take a distribution, the simple way to get the after-tax dollars into a Roth is to convert the entire account. (Through the end of 2009 you have to meet eligibility requirements for a conversion.) Converting the entire account would require you to report the pre-tax dollars as income, however. Is there a way to move only the after-tax dollars to a Roth, without reporting any income? The answer appears to be yes, but only if you follow the awkward procedure described below.
What doesn't work
First, understand what doesn't work. You won't get the desired result if you simply tell the 401k administrator to transfer the after-tax dollars to a Roth IRA. The tax law now allows a direct transfer from a 401k to a Roth IRA, but any distribution from the 401k account is going to be treated as pre-tax and after-tax dollars in proportion to the overall account.
Example: Suppose your $40,000 401k account includes $10,000 of after-tax dollars, and you have $10,000 transferred to a Roth IRA. Instead of moving $10,000 of after-tax dollars, which would allow you to report no taxable income, you're treated as moving $2.500 in after-tax dollars and $7,500 in pre-tax dollars, and you have to report $7,500 in taxable income.
What does
Here's a three-step approach that should work. First, take all your money from the 401k account in a single distribution. Second, put an amount equal to the pre-tax dollars into a traditional IRA. And third, after the partial rollover to the traditional IRA has been completed, put an amount equal to the after-tax dollars into a Roth IRA, making sure you complete this step within 60 days of the distribution.
Example: In the situation just described, you take all the money from your 401k account in a single distribution. You roll $30,000 into a traditional IRA, and after that rollover is complete, you put $10,000 into a Roth IRA.
Why it works
The justification for this strategy comes from two specific provisions of the Internal Revenue Code. First, section 402(c)(2) says that if you take a distribution from a 401k account that consists partly of pre-tax dollars and partly of after-tax dollars, and you roll only a portion of that amount into an IRA, the amount rolled over is treated as coming first from the pre-tax dollars. This means that at the point you've completed the rollover of $30,000 to the traditional IRA, you would not have to report any income regardless of what you do with the rest of the money.
Then section 408A(d)(3) says the amount you report as income when you transfer money from a traditional account to a Roth account is "any amount which would be includible were it not part of a qualified rollover contribution." Well, we just saw that if this amount (the remaining $10,000) were not transferred to a Roth, the amount taxable would be zero, so that means you report zero income when you do transfer it to a Roth.
The IRS hasn't offered guidance specifically blessing this approach. Informal inquiries lead us to believe they are unlikely to object, and in any event the law supporting the strategy seems reasonably clear.
So what's the problem?
This strategy has some drawbacks. For one thing, it requires you to give up any advantages associated with having your money in a 401k account. For example, certain investment opportunities you have in the 401k may not be available in an IRA.
Perhaps more importantly, the strategy described here doesn't work if you make a direct transfer from your 401k to an IRA. If you have $30,000 moved directly from your 401k account to a traditional IRA, the IRS is likely to treat that as a separate distribution, even if you get the other $10,000 distributed from the 401k at the same time. In that case the rule described earlier for rolling part of a distribution doesn't apply, because you rolled the entire amount received in that distribution. This separate distribution was 75% of the account, and it included 75% of your after-tax dollars, so 75% of your after-tax dollars went into the traditional IRA. That's not what you want.
The problem is that a direct transfer is the only way to avoid withholding on a distribution from a 401k account. When you take all your money from this 401k account you won't receive a check for $40,000. The plan is going to withhold $6,000 (20% of the pre-tax amount) and send it to the IRS, so you'll get a check for only $34,000. That's enough to cover the $30,000 you need to roll into a traditional IRA, but you'll have to come up with $6,000 from some other source to complete the subsequent $10,000 transfer to the Roth IRA.
You'll recover the $6,000 that went to the IRS, of course. You can reduce your withholding on other income, cut back on your estimated tax payments, or get it back as a tax refund when you file your return. Not everyone can deal with the short-term cash crunch created by this situation, however.
Possibly we'll get relief at some point in the form of a further change in the law allowing you to accomplish the same result with a direct transfer. For now, though, you need to deal with the withholding problem if you're going to achieve this result.
