After tax conversions to Roth

[BW]

If a plan participant making after tax contributions converts the entire balance to Roth and the plan later fails ACP how would one operationally suggest the ROE be handled? Would you unwind the conversion for amount of the ROE plus earnings and distribute or simply process the ROE from the Roth source?

It may be a difference without distinction since it is all after tax and you just have to deal with the earnings but curious if anyone has dealt with this yet.

[Lou S.]

Process from the ROTH, prorate ROTH basis and earnings.

[BW]

I think that is correct as well.

[Luke Bailey]

Off hand I am not aware of guidance on point and have not looked, but suppose the individual already had his/her Roth account in the plan for 5 years and was over 59-1/2. Wouldn't this result in an unwarranted tax benefit? My guess is the IRS would say you have to unwind the Roth conversion to the extent of the after-tax contributions that fail ACP.

[Lou S.]

I believe the conversion is an irrevocable election so I'm not sure how you would unwind it.

[Luke Bailey]

Right, Lou, it is irrevocable, but we would not be letting employee revoke it, but rather would be saying to employee, "Hey, you know that money in your after-tax that you thought you could convert to Roth? You didn't really have it to convert because it failed ACP, so we're backing it and its earnings out of your Roth and putting it back into your after-tax, temporarily, and then we are distributing with same tax effects as if we had not let you convert it and it had failed ACP so was distributed as such."

[David Schultz]

20 hours ago, Luke Bailey said:

Off hand I am not aware of guidance on point and have not looked, but suppose the individual already had his/her Roth account in the plan for 5 years and was over 59-1/2. Wouldn't this result in an unwarranted tax benefit? My guess is the IRS would say you have to unwind the Roth conversion to the extent of the after-tax contributions that fail ACP.

There is a special Roth conversion "recapture" provision that would prevent the tax windfall.  See Treas. Reg. §1.408A-6 Q&A-5(b) and (c).  Effectively, it applies the 5-year rule separately to each Roth rollover/transfer.

[Lou S.]

21 hours ago, Luke Bailey said:

Off hand I am not aware of guidance on point and have not looked, but suppose the individual already had his/her Roth account in the plan for 5 years and was over 59-1/2. Wouldn't this result in an unwarranted tax benefit? My guess is the IRS would say you have to unwind the Roth conversion to the extent of the after-tax contributions that fail ACP.

I'm not sure how. Isn't there a different code on the 1099-R for an ACP refund than for qualified ROTH distribution?

[Luke Bailey]

4 hours ago, David Schultz said:

There is a special Roth conversion "recapture" provision that would prevent the tax windfall.  See Treas. Reg. §1.408A-6 Q&A-5(b) and (c).  Effectively, it applies the 5-year rule separately to each Roth rollover/transfer. 

David, the 1.408A regs are for Roth IRAs. This is a K-plan and the amount was an in-plan Roth "rollover"/conversion, not a real distribution and rollover.

[Luke Bailey]

3 hours ago, Lou S. said:

I'm not sure how. Isn't there a different code on the 1099-R for an ACP refund than for qualified ROTH distribution? 

Lou S, maybe we are misunderstanding each other. When in your earlier post you said, "Process from the Roth," I thought you meant treat the corrective distribution as a distribution from the Roth account on the 1099-R. I agree (if that's what you're saying) that you would report it on the 1099-R as a refund of an excess after-tax (contribution not taxable, earnings fully taxable), and ignore the fact that the money had taken a temporary detour through the participant's Roth contributions account. Is that what you're saying?

[Lou S.]

17 hours ago, Luke Bailey said:

Lou S, maybe we are misunderstanding each other. When in your earlier post you said, "Process from the Roth," I thought you meant treat the corrective distribution as a distribution from the Roth account on the 1099-R. I agree (if that's what you're saying) that you would report it on the 1099-R as a refund of an excess after-tax (contribution not taxable, earnings fully taxable), and ignore the fact that the money had taken a temporary detour through the participant's Roth contributions account. Is that what you're saying?

I think so. In this case you would process from the ROTH. Let's say for sake of argument that refund is $1,000 and it represents $900 in deferral refunded and $100 in gain refunded.

The 1099-r would show $1,000 refunded, $100 as taxable gain and the ROTH basis in the account would be reduced by $900.

Maybe we are saying the same thing just differently.

[Luke Bailey]

But Lou S., say the participant is over 59-1/2 and had started his Roth contributions account in the K-plan 6 years ago. If you're treating the $100 in your example as taxable, you're not really treating it as coming out of the Roth, I think. That's my point.

[Lou S.]

2 hours ago, Luke Bailey said:

But Lou S., say the participant is over 59-1/2 and had started his Roth contributions account in the K-plan 6 years ago. If you're treating the $100 in your example as taxable, you're not really treating it as coming out of the Roth, I think. That's my point.

I don't see how an ACP refund is a "qualified ROTH distribution".

Say the same situation occurs with a participant over age 59 1/2 with 5+ years of ROTH making only ROTH 401(k) and he receives an ADP refund. Are you saying the gain on that is not taxable?

[Luke Bailey]

Right. Completely agreed. Was my point. Glad we're in agreement in end, Lou S.

[Kevin C]

An ACP refund from a Roth account is not a qualified Roth distribution even if the participant is 59.5 and has had the Roth account at least 5 years.  See 1.402A-1 Q&A 11, which refers you to a list in A-4 of §1.402(c)-2 for types of distributions that are not qualified Roth distributions, including ACP refunds in A-4 (c).

 

[Luke Bailey]

 

12 hours ago, Kevin C said:

An ACP refund from a Roth account is not a qualified Roth distribution even if the participant is 59.5 and has had the Roth account at least 5 years.  See 1.402A-1 Q&A 11, which refers you to a list in A-4 of §1.402(c)-2 for types of distributions that are not qualified Roth distributions, including ACP refunds in A-4 (c). 

 

Right. So even though it may be "processed from the Roth," it's just an excess ACP, as if the in-plan Roth rollover/conversion had not occurred. In effect, to back to the original language of BW's question, you are "unwinding" the conversion to extent of ACP excess amount.

[Kevin C]

I don't think the result would be the same as unwinding the conversion to the extent of the ACP refund.  I would expect the conversion to include some earnings on the participant's after tax accounts, so the conversion should have increased the participant's after tax basis. That would affect the calculation of basis and taxable portion of the refund.

[Luke Bailey]

4 hours ago, Kevin C said:

I don't think the result would be the same as unwinding the conversion to the extent of the ACP refund.  I would expect the conversion to include some earnings on the participant's after tax accounts, so the conversion should have increased the participant's after tax basis. That would affect the calculation of basis and taxable portion of the refund. 

Kevin C, I'm confused. Suppose from prior years participant had $50k in after-tax account, consisting of $40k basis and $10k earnings. In current year, makes a $10k after-tax, then before ACP is run, and after there are an additional $2,000 in earnings on prior $50k and $200 in earnings on new $10k, participant does Roth conversion of whole $62,200. If ACP is not failed, you probably need one 1099-R to report the $10,000 after-tax contribution, in Box 5, and a second 1099-R to show the $62,200 IRR, again in Box 5 of 1099-R. On the 1099-R for the IRR, the $12,200 of income and $50,000 of basis is parsed out in boxes 1 and 2a. Let's suppose ACP is failed, however, and $5,000 of the $10,000 after-tax is distributed as excess aggregate, together with $100 of earnings. I'm thinking that the Roth rollover is reduced to $55k in Box 5 of a corrected 1099-R, and$5,100 is reported on another 1099-R using Code 8 in Box 7, with $5,100 in Box 1 and $100 in 2a. So this (if correct) is really just a complete unwind of the portion of the attempted after-tax that failed ACP, as if had never occurred.

[cdavis25]

Curious, how do you adjust the 1099R when one would be in the prior year for the IRR and the other 1099R would be in the current year when the ACP refund is processed?  Do you process an amended 1099R for the prior year?