Isolating 401k Basis for a Conversion

Examining all the strategies

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No article posted here has prompted more interest than this one. Because there have been so many requests for updates or clarifications I have expanded it to several times its original length, with far more detailed legal analysis.

Suppose you have a 401k account, and suppose further that you have made nondeductible contributions to that account. Because you received no deduction for these contributions they create basis. This means that when you withdraw money from the account you won't have to pay tax on the portion of your distributions representing these dollars. Nondeductible contributions provide a potential tax advantage because investment earnings they produce will not be taxed until you take withdrawals from the account. Invested money grows faster when taxes are deferred, and over long periods of time the miracle of compounding at this higher rate can produce a substantial tax benefit even after taking into account the need to pay tax on these earnings when they are eventually withdrawn.

The tax benefit would be greater, though, if you moved the portion of your account representing nondeductible contributions to a Roth account. Investment earnings in a Roth account are not merely tax-deferred. If you follow the rules, maintaining the account for at least five years and waiting until age 59½ or later to take withdrawals, the investment earnings will be tax-free. Tax-free is a whole lot better than tax-deferred.

You aren't allowed to move money from a regular 401k account to a Roth 401k account. It is possible, however, to move money from a regular 401k account to a Roth IRA. These transfers are familiarly known as conversions. In a conversion you have to pay tax on the pre-tax dollars but not the after-tax dollars. The after-tax dollars are the portion of the conversion that's treated as coming from nondeductible contributions. Everything else, including investment earnings produced by the nondeductible contributions, would be pre-tax dollars.

Two legal developments of the past few years make it easier to do this. One, which took effect in 2008, allows money to flow directly from a 401k account to a Roth IRA without first being rolled to a traditional IRA. The other, which took effect in 2010, removed the income limitation on Roth conversions. This change is important because nondeductible contributions are more likely to be made by high-income individuals.

Depending on your situation, converting pre-tax dollars to a Roth IRA can be a great idea, a neutral move or a bad idea. By contrast, converting after-tax dollars to a Roth IRA is pure gold. You pay no tax as these dollars move from the traditional account to the Roth IRA, and from that day forward all investment earnings they produce will be tax-free rather than tax-deferred, assuming you meet the basic requirements described above. Even if you withdraw the earnings without meeting those requirements you receive the same treatment as if the money had remained in the traditional account (earnings deferred but taxable when withdrawn), so this is a no-lose proposition, offering the potential to convert tax-deferred earnings to tax-free earnings with no downside.

Many people want to convert the after-tax dollars without converting the pre-tax dollars. They may be in a situation where a conversion of pre-tax dollars is not advantageous. I suspect that in some cases they may actually be in a situation where they would benefit from a conversion of the pre-tax dollars but don't realize this is the case. In any event, the opportunity to convert the after-tax dollars without converting the pre-tax dollars has generated intense interest.

It turns out that this is not as easy as people would like. People have tried at least five different ways to do this. The IRS has indicated that two of them do not have the desired tax consequences: they result in taxation of at least some of the pre-tax dollars rather than a tax-free transfer of only the after-tax dollars to the Roth IRA. Two other strategies appear to produce the desired tax consequences but present other problems. The fifth one avoids these problems but in my view presents tax issues making it dangerous. Each of these will be discussed in the remainder of this article. Along the way we'll also look at how you might be able to convert after-tax dollars that are in an IRA instead of a 401k account.

Eligible rollover distribution

As a preliminary matter we should be clear about the requirement for an eligible rollover distribution. Many 401k plans do not permit distributions other than hardship distributions prior to termination of employment. Hardship distributions cannot be rolled over, and therefore they cannot be converted. (Certain other amounts, such as required minimum distributions, are also ineligible for rollover.) This discussion applies to you only if you are able to take an eligible rollover distribution, which means either you have a 401k account at a place where you are no longer employed or you participate in a 401k plan that allows in-service distributions — in other words, distributions to people who are still employed at that company.

Strategy 1: direct conversion of after-tax dollars

The first strategy is the simplest: instruct the employer to make a direct transfer of the after-tax dollars from the 401k to a Roth IRA, while leaving the pre-tax dollars in the 401k account. Initially some experts believed this was possible, but further study of the situation revealed that this belief was mistaken. It was based on language in section 402(c)(2) of the Internal Revenue Code saying "the amount transferred shall be treated as consisting first" of the pre-tax dollars. Careful reading of that section makes it clear that this language referred to the pre-tax dollars in that particular distribution, not the pre-tax dollars in the overall account. When your 401k account includes pre-tax and after-tax money, each distribution includes pre-tax and after-tax money, even if you would like to distribute (and convert) only the after-tax money. The IRS addressed the issue informally in its Fall 2008 Retirement News for Employers newsletter, which says:

"You may not take a distribution of only your after-tax contributions. Any distribution from a retirement plan account in which there is basis is treated as consisting of both pre-tax amounts (your employer's pre-tax contributions and earnings) and your after-tax contributions. The after-tax contribution portion of each distribution is tax-free, but the rest must be included in your gross income. "

The newsletter goes on to provide the formula for determining the fraction of the distribution that is after-tax, and then says, "If you roll over the distribution to a Roth IRA (assuming you meet the income limits and filing status for making rollovers to Roth IRAs), the pre-tax portion (employer contributions and earnings) must still be included in your gross income. . . . These same rules apply if you make a direct rollover to the Roth IRA."

This simple strategy was at one time endorsed by a prominent tax practitioner but I believe it is now agreed by all experts who have studied the question that the approach does not work. If you tell your employer to pay out only the after-tax portion of your 401k and transfer it directly to a Roth IRA, the transfer will be only partly nontaxable.

For example, if your 401k has a total value of $25,000 of which $5,000 represents after-tax dollars, a transfer of $5,000 to a Roth IRA would  be 80% taxable, because 80% of the 401k account consisted of pre-tax dollars. You would report $4,000 of income on this conversion, and you would still have $4,000 of after-tax money in your 401k account.

Strategy 2: split distribution

As practitioners came to realize that Strategy 1 was not viable, some of them advocated a different approach. The owner of the 401k account would request a complete distribution of all the money in the account, with the pre-tax portion going in a direct rollover to a traditional IRA and the remainder going to the account owner, who would roll it to a Roth IRA. This approach was intended to take advantage of language in section 402(c)(2) of the Internal Revenue Code mentioned earlier saying in effect that when you roll money from a 401k to an IRA, the amount transferred is treated as coming first from the pre-tax dollars.

For example, if your 401k has a total value of $25,000 of which $5,000 represents after-tax dollars, you would tell the plan administrator to pay out the entire $25,000, with $20,000 going to a traditional IRA in a direct rollover and $5,000 going to you. The direct rollover of the $20,000 is completed before you do anything with the $5,000 that goes to you, and the tax law says the amount transferred is treated as coming first from the pre-tax dollars. According to this theory, the remaining $5,000 must be after-tax dollars, and you can roll them into a Roth IRA (within 60 days after the distribution) and complete a tax-free conversion of that amount.

The problem with this approach is that it relies on an assumption that the entire payout of $25,000 is a single distribution. It may seem like a single distribution because it's all paid out at the same time pursuant to a single instruction. Yet it's paid to two different recipients, with a portion of the money going to the rollover IRA and another portion going to the account owner. If the payout is considered to be two distributions instead of one distribution that goes to two recipients, then each portion (the part going to the traditional IRA and the part going to you) includes a mix of pre-tax and after-tax dollars.

It appears that a number of practitioners either overlooked this problem or concluded that it was unlikely (or would be inappropriate) for the IRS to treat the payout as two distinct distributions. Yet that is precisely what the IRS chose to do in Notice 2009-68, published in September 2009. In an earlier version of this article, published before the IRS came out with this Notice, I warned of this possible result.

The IRS Notice doesn't directly address the issue. Instead, the notice discusses how employers can meet a requirement to explain rollover distributions to participants in their 401k plans. The Notice includes "safe harbor" explanations employers can copy and hand out to plan participants to satisfy the requirement. The safe harbor explanation includes the statement, "If you do a direct rollover of only a portion of the amount paid from the Plan and a portion is paid to you, each of the payments will include an allocable portion of the after-tax contributions." So, although the IRS has never directly told us the result of this strategy, it says that an explanation of rollover options given to plan participants should include this unfavorable interpretation.

Is the IRS correct? The American Benefits Council has sent a letter dated October 26, 2009 to the IRS objecting to this interpretation, saying it's inconsistent with prevailing practice and also that it's incorrect. In describing the tax consequences of rolling over a Roth 401k account, however, the tax regulations explicitly state that "any amount paid in a direct rollover is treated as a separate distribution from any amount paid directly to the employee." (Reg. 1.402A-1, Q/A 5(a)). It isn't much of a stretch for the IRS to say the same rule applies when money comes out of a regular 401k account. In any event, the IRS is now on record saying, albeit indirectly, that Strategy 2 doesn't work.

Strategy 3: single distribution to owner, two rollovers

Our third approach requires three steps. First you would tell the company to pay the full balance of your account to you, rather than doing a direct rollover. Next, you deposit an amount equal to the pre-tax dollars in a traditional IRA. Finally, you deposit an amount equal to the after-tax dollars in a Roth IRA. The two IRA deposits must take place within 60 days after the distribution to qualify as rollovers. To put you on the strongest legal ground, the deposit to the Roth IRA should occur at least a day after the deposit to the traditional IRA. To avoid any possible confusion you should obtain positive confirmation that the deposit of the pre-tax dollars to the traditional IRA has been properly recorded before proceeding with the deposit of the after-tax dollars to the Roth.

How does this work? After the first step, it's clear that you've received a single distribution that includes both pre-tax dollars and the after-tax dollars. The second step is governed by the last sentence of section 402(c)(2) of the Internal Revenue Code, which says that when you receive a distribution from an employer plan and make a transfer to an IRA, "the amount transferred shall be treated as consisting first of the portion of such distribution that is [pre-tax dollars]." In other words, this partial rollover to the traditional IRA does not get proportional treatment. If you stopped here (without the third step, where you deposit the after-tax dollars in a Roth IRA), it's clear that you would pay no tax on the distribution. The IRS confirms this in the safe harbor explanations in Notice 2009-68 described earlier.

Although the IRS does not go on to confirm the consequences of the third step, it seems reasonably clear that you are entitled to roll the remaining money into a Roth IRA, and that you report no taxable income on this transfer because you have already rolled all the pre-tax dollars to a traditional IRA. We get support for this result from section 408A(d)(3), which says the amount you report as income when you transfer money from a traditional account to a Roth IRA is "any amount which would be includible were it not part of a qualified rollover contribution." In other words, we have to ask how much income you would have been required to report if you didn't roll this money into the Roth IRA. The answer, as we've seen, is zero.

I don't see any reason to doubt that this procedure will withstand scrutiny from the IRS, as it fits precisely within the language of the tax law. There is a problem with this strategy, though, and for many people it's a big one: the tax law requires withholding at the rate of 20% on pre-tax dollars distributed from a 401k account unless they go to another plan or an IRA in a direct transfer. Your intention to complete a rollover doesn't excuse the plan administrator from the duty to withhold this amount when making a distribution.

Consider the situation where you have $1,000,000 in your 401k account, including $200,000 of after-tax dollars. In the first step of this strategy you receive only $840,000, because $160,000 (20% of the pre-tax dollars) is withheld and paid to the U.S. Treasury. You can complete the second step, transferring $800,000 to a traditional IRA. After that you may have a problem. You're allowed to transfer $200,000 to a Roth IRA, completing the tax-free conversion, but you have only $40,000 left from the distribution. To complete the third step you would need to come up with $160,000 from another source. Eventually you'll get a big refund after filing a tax return showing you have zero taxable income from the distribution because of the rollover, but in the meantime you're out of pocket $160,000.

Unlike strategies 1 and 2, this one passes legal muster as a way to convert the after-tax dollars in a 401k to a Roth IRA without paying tax on the pre-tax dollars. The withholding problem is a major obstacle in using this strategy, however.

Strategy 4: isolating basis in an IRA

Our fourth strategy is actually a way to isolate basis when converting an IRA rather than a 401k account. The method can be used for a 401k account, however, if you first roll that account to an IRA. It isn't available to everyone, but if you're lucky enough to have this opportunity you can use it to convert your after-tax dollars without paying tax on the pre-tax dollars — and without the withholding problem we encountered with strategy 3.

Prior to 2002 the rules for rollovers between employer plans and IRAs were different. If you were rolling from an employer plan to an IRA, you could roll only the pre-tax dollars. Assuming you rolled the pre-tax dollars to an IRA, you would receive the after-tax dollars without paying any tax, but these dollars would no longer be held in a retirement plan. Going in the other direction, an employer plan was permitted to accept a rollover from an IRA provided that the IRA consisted only of money received as a result of a rollover from an employer plan, plus any earnings on the rollover money. Note that an employer plan accepting a rollover from an IRA would be accepting only pre-tax money, because it could accept money only from a rollover IRA, and a rollover IRA could not contain any after-tax money.

A law passed in 2001 changed the rollover rules, effective in 2002. A rollover from an employer plan to an IRA can now include after-tax dollars. What's more, employer plans are now permitted to accept rollovers from IRAs without the previous restriction that they contain only money received in a rollover from an employer plan. However, only pre-tax money can be rolled from the IRA to an employer plan.

If you can roll all the pre-tax money from an IRA to an employer plan, it seems reasonably clear that you are left with only after-tax money, which can be rolled to a Roth IRA without reporting any taxable income. We have no guidance from the IRS on how it works, however, other than a cryptic statement on page 24 of Publication 590 saying that if you rolled money from an IRA to an employer plan you should "attach a statement explaining what you did" when you file your tax return. This is a problem because there appears to be a mismatch between what Congress intended with this rule and the language that appears in the law.

Suppose you have a $25,000 IRA that includes $5,000 of after-tax money. If Congress wants you to be able to move the $20,000 of pre-tax money to an employer plan, it seems logical that you should be able to withdraw $20,000 from your IRA, leaving $5,000 behind, and transfer that $20,000 to the employer plan. The Conference Committee Report accompanying the 2001 tax law indicates this is what was intended: "In the case of a distribution from a traditional IRA that is rolled over into an eligible rollover plan that is not an IRA, the distribution is attributed first to amounts other than after-tax contributions." This is not what the actual law says, however. In section 408(d)(3)(A)(ii) it says, "the maximum amount which may be paid into such plan may not exceed the portion of the amount received which is [pre-tax money]." Congress didn't change rule for determining what portion of the amount received is treated as pre-tax money, so if we apply this language literally, only 80% of the distribution from the IRA, or $16,000, is treated as pre-tax money that is eligible to be rolled to an employer plan.

It isn't clear that the IRS will insist on this literal reading of the law. If you've already done something like this, I suspect there's little chance the IRS will challenge the result. If you're planning this transaction, however, it appears to be at least somewhat safer to operate within the literal language of the law as follows: (1) withdraw the entire $25,000 from the IRA, then (2) transfer $20,000 to the employer plan, and finally (3) after the transfer to the employer plan is completed, and within 60 days after the distribution from the IRA, roll the remaining $5,000 into a Roth IRA.

A few observations are in order. First, although the tax law allows retirement plans to accept these rollovers, it does not require them to do so. For a variety of reasons your company may have determined that it is undesirable to accept rollovers from IRAs. Second, if you have more than one traditional IRA, you have to treat them as a single IRA for this purpose, and that means withdrawing all money from all your traditional IRAs in step (1) of the previous paragraph. And third, contributions or rollovers to a traditional IRA within the same year, occurring after you've performed this maneuver, can retroactively change the ratio of pre-tax and after-tax money as it would be calculated for this purpose. After emptying your traditional IRAs, you should avoid creating a new one before the end of the year, or making a contribution for that year during the following year (which is permitted until April 15).

As indicated earlier, this procedure can be used to isolate basis in a 401(k). You would begin by rolling the entire 401k account to a traditional IRA in a trustee-to-trustee transfer. This is a tax-free transaction and does not require withholding. Then proceed as indicated above, taking all the money from this IRA (and any other IRAs you own), rolling the pre-tax money to your 401(k) account, and finally rolling the after-tax money to a Roth IRA.

Strategy 5: single check for two IRAs

Strategy 3 may be unattractive because of the withholding requirement, and strategy 4 isn't available unless you participate in an employer plan that will accept rollovers from IRAs. For these reasons, some people have considered yet another strategy. Under this approach you would have your entire 401k account distributed in a single check made out to the financial institution where you will maintain your traditional and Roth IRAs. The financial institution would be instructed to deposit the pre-tax money in a traditional IRA and the after-tax money in a Roth. It appears that the theory behind this arrangement is that it will be treated as a direct transfer, so that no withholding is required, and it will be treated as a single distribution because the money is paid out in a single check to a single payee.

This analysis is subject to challenge, however. To have a direct transfer within the meaning of these rules, you must make a direct transfer to an eligible retirement plan (section 401(a)(31)(A)). The IRS may take the view that a check that isn't to be deposited directly into a particular IRA fails to meet this requirement.

Furthermore, an income tax regulation (section 1.401(a)(31)-1 Q/A 10) can be read as indicating that when direct rollovers go to two or more IRAs or other plans, each direct rollover is treated as a separate distribution. It seems unlikely that combining two transfers in a single check would cause them to be treated as a single distribution when the regulation indicates otherwise.

Although this strategy looks good on the surface, it could be a recipe for disaster. The exception from withholding on direct transfers (section 3405(c)(2)) applies only "if the distributee elects under section 401(a)(31)(A) to have such distribution paid directly to an eligible retirement plan." If the IRS doesn't accept the view that this procedure qualifies as a direct transfer, the plan administrator is exposed to a possible penalty for failing to withhold. Meanwhile, as we saw in the discussion of strategy 2, the account owner could face an unexpected tax bill as a result of having two separate distributions from the 401k account, with each one treated as consisting partly of pre-tax money and partly of after-tax money. Advisors who have recommended this strategy may want to reconsider their advice.

Final thoughts

The issue of isolating basis in a 401k account for conversion to a Roth IRA involves many complicated provisions of the tax law. As a result some authors, including some of the leading experts in this area, initially believed strategies 1 or 2 were viable. Their statements to that effect may still appear on various web pages where their initial opinions have been quoted, even if these experts have now changed their views. Naturally I can't speak for all IRA experts, but I believe most have come around to the view that strategy 1 is not viable, and that strategy 2 entails unacceptable risk now that the IRS has published a safe harbor explanation that describes consequences different from those that are intended.

When I discussed strategy 4 with someone at the IRS, I had the impression he felt it was somehow illegitimate, although he did not find fault with the legal analysis. The strategy is admittedly somewhat convoluted, involving transfers from a 401k account to an IRA and then back again. Yet the same result is available from strategy 3, with the only difference being that strategy 4 eliminates the withholding requirement in a situation where withholding is pointless. If strategy 3 is legitimate tax planning, then strategy 4 should also be considered legitimate tax planning as well.

The larger question is whether Congress truly intended to create opportunities for isolating basis prior to a Roth conversion. It's fair to say, as the American Benefits Council has argued, that Congress has pursued a policy of making retirement benefits more portable in liberalizing the rules for rollovers. It's less clear, however, that Congress ever intended to permit the people holding after-tax money in their retirement accounts to move that money to a Roth IRA without paying tax on the pre-tax money. Provisions creating the opportunity to do so appear to have been adopted for other reasons. Arguably, permitting these dollars to move freely to a Roth IRA defeats the purpose of other rules that caused these dollars to be after-tax money in the first place. What's more, it would be a simple matter for Congress to change the law to permit such transfers if this was the intent.

The current situation is not stable. The IRS has yet to offer guidance on many of these issues. More importantly, the taxwriters in Congress haven't come to grips with the situation. Developments of one kind or another are to be expected. For now, the direction of those changes is hard to predict.