401K rollover to IRA, then conversion to ROTHIRA and prorata

[Guest BigAl]

I'm having difficulty understanding why the after-tax contributions portion of a 401K, when rolled over into a separate IRA from the pretax funds, thusly 2 separate IRAs, and then the after-tax IRA is converted to a ROTH, why is there a tax liability because of the other existing pre-tax IRAs, due to prorata. Could someone explain the prorata, and why other existing IRAs effect the newly converted after-tax IRA to a ROTH.

[Appleby]

BigAl,

According to the IRS, if a distribution, including a Roth Conversion is being taken from a traditional IRA, the distribution/conversion must be taxed pro-rata, if any one of the IRA owned by the individual requesting the distribution/conversion includes non-deductible contributions (This is explained in IRS form 8606 and its instructions, which may be found a www.IRS.Gov

The IRS has not yet stated definitively that this rule applies to after tax assets that are rolled to a traditional IRA. However, IRA practitioners are playing it safe by advising their IRA owners to rely on the rules that are applied to non-deductible IRA contributions. This means that the IRA owner must file IRS form 8606 for the year the after tax assets are being rolled to the traditional IRA, and also for any year that a distribution or Roth conversion is done -after these non-taxable/non-deductible assets are credited to the IRA.

There may be one way around this. That is, if the individual has zero IRA balance and takes a distribution from the QP. Hold back the taxable portion and roll only the after tax portion to the traditional IRA. This would mean that the total traditional IRA balance would be non-taxable. The IRA owner would then convert this amount to a Roth IRA. The balance of the QP distribution, which is taxable, could then be rolled to the traditional IRA (within sixty days) after the non-taxable assets have been converted to a Roth. Seems logical, but still… I am sure the IRS would find a way to make such actions unacceptable… yet, if this is done cross years, where the second rollover of taxable portion is done in the year following the year the conversion was done ( but within sixty days after the distribution form the QP- this would mean of course that the distribution from the QP would have to be done close to year-end), the IRS would be hard pressed to force someone to include the after-tax portion in the equation, since the year that the conversion was done to the Roth IRA, the IRA owner’s balances were all non-taxable.

[Appleby]

BigAl,

After reviewing the Job Creation and Worker Assistance Act (JCWAA) of 2002 (Technical Corrections to EGTRRA), it is apparent that my “way around this” does not exist. According to JCWAA, if a rollover of a distribution from a qualified plan includes pre-tax and post-tax assets, any amount rolled over will be deemed to include the pre-tax portion first.

This means that there is no way to avoid the pro-rata treatment of amounts distributed or converted ( to a Roth IRA) from the traditional IRA

[Guest BigAl]

Thanks, Appleby. I usually prepare my own income taxes, however, with the pending rollover and possible IRA conversion to ROTH and form 8606's complexities, I have been referred to a CPA in my area. I mentioned to him what he thought about the after tax rollover, and to my surprise he said it was no problem, and that he has done it many times. I am sending him more specific information on the matter, such as all my other IRAs and the full amount of the after tax and pre-tax dollars in the 401K. It will be interesting to see what his final thought will be, since I am quite convinced by you and others on this board, that it can't be done.

[Appleby]

What has he done many times?

Convert only the after-tax portion?

Maybe what he means is that he has used the Form 8606 many times, to determine the taxable portion of a conversion, when the IRA owner has both after and pre-tax assets? I hope this is what he means.

[Guest BigAl]

I had explained to him that my 401K had both pre-tax and after-tax funds, and that I had hoped to rollover those funds into 2 separate accounts, one for pre-tax and one for after-tax, and then convert the after-tax IRA to a ROTH, and incurr no tax liabilities. His response was, "no problem, I have done it many times". Perhaps when he gets all the info I sent him, he will re-evaluate the situation. I will keep you posted.

[BPickerCPA]

Al,

I've seen many things done many times, all of them wrong. Just remember that ultimately YOU are responsible for the tax return.

Ask him if he'll write a memo to you explaining why his position is legally correct, and ask if he'll indemnify you against penalties.

He might not be the right pro for your circumstances.

Just a thought.

[Guest franky]

Would this work as a "way around?" Rollover all of before-tax dollars from Traditional IRA to QRP, then convert balance (After-tax dollars) to Roth.

[Guest fsokolowski]

Another 401K rollover question...If one rolls a 401K to an IRA, are they able to use 10,000 from IRA for first time Home Buying Expense? Is there any time it needs to be an IRA. The roll over was created when someone lost a job. I realize it will be taxable, but can they fit the exception for first time home Buyer> I spent an hour today going through I believe it is 575 and could find nothing..Thank You Fred Sokolowski EA

[papogi]

There is no time period that an IRA created via a 401(k) rollover needs to be an IRA in order to take advantage of the first-time home buyer provision. You'll pay tax, but you won't pay the 10% penalty.

[mbozek]

Yo Al: If you have a CPA who is willing to sign your tax return stating that you can rollover the after tax funds to a separte roth IRA then by all means go for it-- YOu have relied on a tax professional -- Your only liability would be to pay any taxes and interest if the IRS audits you. (IRAs are rarely audited by the IRS because there is no formal way for them to check on the millions of rollovers each year.) By the way I dont think you can do a separate rollover but you are not paying me to be your advisor. You should not be liable for any penalities for substantial underpayment of taxes because you relied on your professional who could be disciplined by the IRS. Attorneys write such opinion letters for clients all the time. This is why people retain professional tax advisors -- to avoid paying penalites if the advisor is wrong.

[Guest franky]

Thanks Appleby, but what I meant was roll over all of pre-tax dollars to a QRP. EGTRRA allows rollover from T IRA to QRP of pre-tax dollars. Then convert remainder of T IRA to R IRA. T IRA will contain only after-tax dollars (and maybe small amount of earnings from the date all pre-tax funds are rolled over from T IRA to QRP to the date of the conversion -- maybe none if rollover to QRP and conversion to Roth are done on same day). Wouldn't conversion be tax-free? I'm not sure how many QRPs accept rollovers of T IRA funds, but it appears to me that if the individual is a participant in a QRP that does, this could be a way to get all after-tax dollars moved to a Roth IRA without having to pro-rate.

[Guest BigAl]

Thanks, mbozek, for your opinion on choosing and relieing on tax professionals. I am waiting to see how my CPA handles the rollover situation. I will keep the board posted. And, Franky, your thoughts on the after-tax rollover, are also my feelings, as I have posted earlier, however, I am not sure as to what you mean by T IRA and R IRA. Could you please clear that issue. I'm not sure if you have read my earlier posts on this topic, and the in-depth responses from BPicker, Appleby, John G and others. This is obviously a very interesting and involved topic. Hopefully we will keep the responses coming and enjoy the exchange of dialogue. Good job, fellas!!

[Guest franky]

Sorry BigAl, T IRA = Traditional IRA -- R IRA = Roth IRA

[Guest Fishchick]

Franky, I believe that you could do exactly what you suggested. That is the only way that one can access after-tax IRA monies without having to do so pro-rata.

As far as the accountant's having "done it many times." I have to say I challenge this because this is the first year that one could rollover after-tax money to an IRA, so how could he have done it "many times."

Before you convert to Roth, also, please understand the rules for eligiblity, and the rules for recharacterizing in case you later become ineligible or decide you don't want to pay the taxes (there's no avoiding them). I have talked to so many grumpy people who converted and later recharacterized, and because of the way the recharacterization calculation worked out, felt absolutely screwed.

[Appleby]

Thanks Appleby, but what I meant was roll over all of pre-tax dollars to a QRP.  EGTRRA allows rollover from T IRA to QRP of pre-tax dollars.  Then convert remainder of T IRA to R IRA.  T IRA will contain only after-tax dollars (and maybe small amount of earnings from the date all pre-tax funds are rolled over from T IRA to QRP to the date of the conversion -- maybe none if rollover to QRP and conversion to Roth are done on same day).  Wouldn't conversion be tax-free?  I'm not sure how many QRPs accept rollovers of T IRA funds, but it appears to me that if the individual is a participant in a QRP that does, this could be a way to get all after-tax dollars moved to a Roth IRA without having to pro-rate.

I know I’m very late on this but (checking for something and came across the post) … or maybe I didn’t post because Fishchick already posted the right answer...anyway, it seems your suggestion would be the only workaround franky.