Mega Backdoor Roth

[brooklynguy]

Has anybody done this?  Under the right circumstances, this will allow someone to do the equivalent of a backdoor roth contribution well in excess of the normal limits.

http://whitecoatinvestor.com/the-mega-backdoor-roth-ira/

[shuffler]

Yes.

http://forum.mrmoneymustache.com/investor-alley/after-max-401k-and-roth-ira-what-to-do-next/msg277728/#msg277728

[brooklynguy]

Thanks!  I had tried searching the forum before posting but came up empty.  I was specifically looking for information on whether an analog to the pro rata rule for regular backdoor Roth contributions might apply to this strategy, so the discussions in those threads are very helpful.

[4alpacas]

Has anybody done this?  Under the right circumstances, this will allow someone to do the equivalent of a backdoor roth contribution well in excess of the normal limits.

http://whitecoatinvestor.com/the-mega-backdoor-roth-ira/

My company has the option to do this, and I'm looking into it.  Please post how your experience goes!

[catccc]

I just posted a topic similar.  I am in the process of doing this.  Not with a huge amount, but same principle.  Contributed after tax money to a 401K that will be in excess of the $17.5K pre-tax max.  Left the employer in March and will roll the after-tax portion into a Roth.  I had someone question the move, but as soon as I've confirmed this works as expected, I'll go ahead with it.

Did speak to a Vanguard representative yesterday about it, who told me that I can do what I'm proposing.  There's a nominal gain on the after tax portion, and she volunteered that the gain would get added to the pre-tax portion of the 401K and rolled over into the traditional roth, thereby eliminating the trigger of a taxable event.  That last part (if she's accurate) was a pleasant surprise.

[4alpacas]

I just posted a topic similar.  I am in the process of doing this.  Not with a huge amount, but same principle.  Contributed after tax money to a 401K that will be in excess of the $17.5K pre-tax max.  Left the employer in March and will roll the after-tax portion into a Roth.  I had someone question the move, but as soon as I've confirmed this works as expected, I'll go ahead with it.

Did speak to a Vanguard representative yesterday about it, who told me that I can do what I'm proposing.  There's a nominal gain on the after tax portion, and she volunteered that the gain would get added to the pre-tax portion of the 401K and rolled over into the traditional roth, thereby eliminating the trigger of a taxable event.  That last part (if she's accurate) was a pleasant surprise.

Do you have to wait until you leave the company?  I was hoping to do it annually while still working at the company.

[catccc]

It depends on the way your company set up the plan.  If it allows in-service distributions, you don't need to wait until you leave, if I understand correctly.  FWIW, I didn't know I was going to leave the company.  I was just going to pay the taxes on the gains when I did leave.  Essentially treat it like a taxable account (that I couldn't touch) that was Roth-ify-able whenever I did leave.  I figured I'd still come out ahead paying taxes on the gains until Roth conversion, then get a tax break on gains between conversion and distribution.

[shuffler]

If it allows in-service distributions, you don't need to wait until you leave, if I understand correctly.

I believe what I've done is called an in-service rollover.  It's not a distribution; at least not outside of the plan.
The money stays within the 401k plan, but the tax-treatment changes.  No IRA is involved.

[shuffler]

I believe what I've done is called an in-service rollover.

I was mistaken.  It's called a "conversion".

Our HR department encourages us (or at least tells us) that this is a benefit of the plan.
They say:

A Roth In-Plan Conversion is a distribution from an individual's plan account that is rolled over or converted to a Roth balance within the same plan. For example, in the 401(k) Plan, if you have After-Tax (non-Roth) or rollover money, you now have the option to convert this to a Roth within the plan.

[4alpacas]

I believe what I've done is called an in-service rollover.

I was mistaken.  It's called a "conversion".

Our HR department encourages us (or at least tells us) that this is a benefit of the plan.
They say:

A Roth In-Plan Conversion is a distribution from an individual's plan account that is rolled over or converted to a Roth balance within the same plan. For example, in the 401(k) Plan, if you have After-Tax (non-Roth) or rollover money, you now have the option to convert this to a Roth within the plan.

Thanks!  This is really helpful.  I need to ask a few questions of our plan to see if it's viable.  It's definitely after-tax, and I think it's kept in a separate 'bin' for easy separation.  Now I just need to see if I can do an in-plan conversion to a Roth IRA. 

[brooklynguy]

After extensively researching this, it looks like there have been a few voices saying the tax treatment of this strategy is not entirely free from doubt.

See, for example, this discussion:

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=137366

Does anyone here have any additional light to shed on whether:

(1) there might be a 401k analog to the pro rata rule for regular back door Roth conversions (i.e., if you have traditional 401k funds, the conversion of the after-tax account could be prorated across the entire 401k balance)?

(2) if you structure this as a direct rollover into a private Roth IRA, whether the pro rata rule is a problem if you have existing traditional IRA funds?

Thanks.

[Edit:  I'm posting the same question in the other active thread on this topic.]

[Trirod]

After extensively researching this, it looks like there have been a few voices saying the tax treatment of this strategy is not entirely free from doubt.

See, for example, this discussion:

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=137366

Does anyone here have any additional light to shed on whether:

(1) there might be a 401k analog to the pro rata rule for regular back door Roth conversions (i.e., if you have traditional 401k funds, the conversion of the after-tax account could be prorated across the entire 401k balance)?

(2) if you structure this as a direct rollover into a private Roth IRA, whether the pro rata rule is a problem if you have existing traditional IRA funds?

Thanks.

[Edit:  I'm posting the same question in the other active thread on this topic.]

I'm a CPA that had a client ask me about this.  I did some research and my opinion was that there was way too much uncertainty to be able to recommend this strategy.  The main issue is that I believe that the after-tax contributions in a 401(k) have to be maintained in a separate sub-account by the employer, and I don't think many employers do this.  Michael Kitces has a good article on this, with links to some other discussions:

http://www.kitces.com/blog/splitting-after-tax-401k-distributions-for-roth-conversion/

[medinme]

The IRS provided an update in Dec 2013-
http://www.irs.gov/pub/irs-drop/n-13-74.pdf

This is probably the best summary of the updated rules-
http://www.forbes.com/sites/ashleaebeling/2014/01/03/the-in-plan-401k-roth-conversion-strategy/

Basically retirement plans are now allowed to provide in plan re-characterizations of after tax 401K to Roth 401K-
I checked with Fidelity for my plan and they allow 2X year-

If you are to down this route it is best to first check with your workplace plan to see if they allow it -

Fidelity said my plan also allows after tax 401k rollover to Roth IRA but I was also wary of 401K weighting and likely more paperwork so for now just looking at in plan conversion option.

A lot of the concerns (Reply 10 and 11) are referencing material prior to this update-

[TLV]

My employer added this last year. Previous thread discussing it.

I contributed the max allowed and had it converted right away. Taxable income when filing earlier this year was increased by the amount the contributions had gained before the conversion happened (since it took several paychecks to hit the max, and conversion is only allowed once per calendar quarter in my 401k).

[shuffler]

The main issue is that I believe that the after-tax contributions in a 401(k) have to be maintained in a separate sub-account by the employer, and I don't think many employers do this.

My plan does do this.  I can see lifetime-contributions and present-values for each of the 'pre-tax', 'after-tax', and 'Roth In-Plan Conversion' segments of the account.  (There's another one for 'employer contributions' too, but that doesn't come into bearing here.)

I can tell that I've contributed $XXX as after-tax, and that the present after-tax value is $0, because the Roth-in-plan-conversion balance has all of those $XXX funds now.

The plan is run by Fidelity, if that helps anyone.

[brooklynguy]

Thanks for the responses.  My 401k plan allows after-tax contributions, maintains them in a segregated subaccount, and permits in-service withdrawals of the same up to twice per year, but does not permit in-plan rollovers/conversions.  So the only way to get the after-tax subaccount balance into a Roth account is to take a withdrawal directly into a private Roth.  The IRS guidance cited above deals only with in-plan rollovers/conversions.  It sounds like there may still be some doubt as to whether the pro rata rule is a problem for direct withdrawals into private Roth (both with respect to the 401k subaccounts not being withdrawn and/or with respect to any private traditional IRA accounts already in existence).  Anyone disagrees with this summary of the current state of affairs?

[Undecided]

Thanks for the responses.  My 401k plan allows after-tax contributions, maintains them in a segregated subaccount, and permits in-service withdrawals of the same up to twice per year, but does not permit in-plan rollovers/conversions.  So the only way to get the after-tax subaccount balance into a Roth account is to take a withdrawal directly into a private Roth.  The IRS guidance cited above deals only with in-plan rollovers/conversions.  It sounds like there may still be some doubt as to whether the pro rata rule is a problem for direct withdrawals into private Roth (both with respect to the 401k subaccounts not being withdrawn and/or with respect to any private traditional IRA accounts already in existence).  Anyone disagrees with this summary of the current state of affairs?

Certainly "there may be some doubt" in that it's not directly addressed in service guidance or case law, but what exactly is the source of your concern that the after-tax sub account withdrawal won't be treated as exactly that? In other words, if you're permitted to withdraw only the after-tax sub account, on what basis do you think it would be prorated with the other sub account? Service rulings do acknowledge that the separate sub accounts are separate 'contracts,' right (http://www.irs.gov/pub/irs-wd/0243054.pdf). A withdrawal from the after tax sub account is pro rated over contributions and earnings in that sub account, but why, specifically, do you think it would be pro rated across all sub accounts? If you made your withdrawal to a traditional IRA (not a Roth IRA), would you have the same concern? I'm not trying to be difficult, but would like to focus in on what you see as the basis for the application of pro rata treatment across all sub accounts for an in-service withdrawal permitted by the plan to be made from only the after-tax sub account.

Also check out http://retirementlc.com/documents/20120528reportingdistributionsofafter-taxcontributions.pdf

[msilenus]

Thanks for the responses.  My 401k plan allows after-tax contributions, maintains them in a segregated subaccount, and permits in-service withdrawals of the same up to twice per year, but does not permit in-plan rollovers/conversions.  So the only way to get the after-tax subaccount balance into a Roth account is to take a withdrawal directly into a private Roth.  The IRS guidance cited above deals only with in-plan rollovers/conversions.  It sounds like there may still be some doubt as to whether the pro rata rule is a problem for direct withdrawals into private Roth (both with respect to the 401k subaccounts not being withdrawn and/or with respect to any private traditional IRA accounts already in existence).  Anyone disagrees with this summary of the current state of affairs?

There is definitely controversy on the pro-rata rule.  Your task, as an investor, is to determine if one side is comprised entirely of idiots.  The presence of controversy does not mean unknowability.  When you're researching this for yourself, be sure to continue to draw the distinction between IRA rollovers and in-plan conversions.  Also be sure to draw the distinction between people who are saying that IRA rollovers trigger pro-rata tax within the entire plan versus within the after-tax subaccount.. There are lots of credible people making good claims that the latter is the case, and I believe them, but it's easy to confuse their arguments for the other thing.  (There are also people claiming that you can do clever tricks to completely isolate your basis within the AT subaccount, and wind up with all your basis in a Roth IRA and your gains in a tIRA, and wind up owing no tax whatsoever on the conversion.  I don't buy that, but some fiduciaries will let you try it.)

I think Trirod sort of nailed it, except it's actually really easy to figure out if there are segregated subaccounts (as you have clearly determined), and I suspect most major fiduciaries do this by now.  Ask, for sure.

If segregated subaccounts are allowed under the law and your plan provides them, and if pro-rata treatment is still required on withdrawals, then what the hell does a segregated subaccount mean?  I haven't seen a compelling answer to this question from anyone saying this is unpossible.  Most seem to just throw up their hands and scream "Controversy! Uncertainty!  Run!"

I think you're right that the IRS guidance is more clearly in favor of in-plan conversions than IRA rollovers.  But I think the case for IRA rollovers is also pretty strong, and you have a lot more security in numbers there.  Almost no one does in-plan conversions, but the IRA rollovers are very popular.  It would be very hard for the IRS to suddenly come out and say the IRA rollovers are disallowed without grandfathering a lot of past behavior and giving plan administrators time to adjust.

[Undecided]

(There are also people claiming that you can do clever tricks to completely isolate your basis within the AT subaccount, and wind up with all your basis in a Roth IRA and your gains in a tIRA, and wind up owing no tax whatsoever on the conversion.  I don't buy that, but some fiduciaries will let you try it.)

I agree with your overall reaction, but I don't think I've seen this claim. I have seen a claim that requires going a step further, and isolating the basis first outside of the AT subaccount---that is, to make an incoming rollover to your 401(k) from the tIRA that held an amount equal to the earnings included in the initial distribution of after-tax contributions and related earnings from your 401(k). Given that only non-basis money can be rolled into a 401(k), this actually makes sense to me.

[brooklynguy]

Certainly "there may be some doubt" in that it's not directly addressed in service guidance or case law, but what exactly is the source of your concern that the after-tax sub account withdrawal won't be treated as exactly that? In other words, if you're permitted to withdraw only the after-tax sub account, on what basis do you think it would be prorated with the other sub account? Service rulings do acknowledge that the separate sub accounts are separate 'contracts,' right (http://www.irs.gov/pub/irs-wd/0243054.pdf). A withdrawal from the after tax sub account is pro rated over contributions and earnings in that sub account, but why, specifically, do you think it would be pro rated across all sub accounts? If you made your withdrawal to a traditional IRA (not a Roth IRA), would you have the same concern? I'm not trying to be difficult, but would like to focus in on what you see as the basis for the application of pro rata treatment across all sub accounts for an in-service withdrawal permitted by the plan to be made from only the after-tax sub account.

Also check out http://retirementlc.com/documents/20120528reportingdistributionsofafter-taxcontributions.pdf

It's not that I have any specific reason to believe that it would be pro rated across all subaccounts.  It's just that when I first read about the possibility of doing a "mega back door roth" via after-tax 401k contributions, my first thought was that it sounds analogous to doing a normal backdoor roth (but using after-tax 401k contributions instead of non-deductible tIRA contributions).  So I worried that there may be an analog to the pro-rata rule (and the other 401k subaccounts would be the tIRA in the anology).  And as I researched this, I saw that some people have expressed concern that proration could be required.  See, e.g., the discussion in this thread:

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=137366&sid=8937589172d591e27269d19b4cd2a10e&start=50

I'm just trying to determine the level of risk involved in this strategy, because the benefit of Roth over taxable account is marginal to me (because I don't plan on having to pay much (or any) taxes in early retirement and the investments will be tax efficient until then).

[Undecided]

And as I researched this, I saw that some people have expressed concern that proration could be required.  See, e.g., the discussion in this thread:

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=137366&sid=8937589172d591e27269d19b4cd2a10e&start=50

I'm just trying to determine the level of risk involved in this strategy, because the benefit of Roth over taxable account is marginal to me (because I don't plan on having to pay much (or any) taxes in early retirement and the investments will be tax efficient until then).

I have read all that and I know that a poster (ArthurO) "expressed concern," but he doesn't point to any provision, or ruling, or any sort of authority, as far as I know, so, to msilenus's point, people yelling "Controversy! Uncertainty!  Run!" without saying why don't really add anything of usefulness to the evaluation, do they?

[brooklynguy]

I have read all that and I know that a poster (ArthurO) "expressed concern," but he doesn't point to any provision, or ruling, or any sort of authority, as far as I know, so, to msilenus's point, people yelling "Controversy! Uncertainty!  Run!" without saying why don't really add anything of usefulness to the evaluation, do they?

Nope.  But the informative contributions of the posters in this thread do.  As I said, I'm just trying to ascertain the level of risk involved.  If the "controversy" were simply a handful of naysayers expressing doubt in the face of an irrefutable answer to the contrary, I would gauge the risk differently than if there were legitimate uncertainty because of a lack of clarity in the law.  It sounds like the actual state of affairs is somewhere in the middle, closer to the latter.

What about the fact that I have an existing tIRA account?  Is there any reason to believe that that could complicate the direct rollover of the after-tax 401k into the private Roth (the way it would if I were doing a conventional backdoor roth conversion)?

[medinme]

The official handling of after tax 401K funds to Roth IRA is listed here-

http://www.kitces.com/blog/splitting-af ... onversion/

Under IRC Section 402(a), distributions from employer retirement plans generally follow the rules of IRC Section 72 (or specifically, IRC Section 72(e)(8)), which states (with respect to qualified plans) that taxable distributions will be treated as including a pro-rata share of any "investment in the contract" (i.e., cost basis, or after-tax contributions).


No further updates have been given in regard to how Fidelity and Vanguard now segregate and track the after tax accounts-So plans may allow it but they are not subject to repercussions of IRA conversions should IRS decide to close the loophole.

[msilenus]

The official handling of after tax 401K funds to Roth IRA is listed here-

http://www.kitces.com/blog/splitting-af ... onversion/

Under IRC Section 402(a), distributions from employer retirement plans generally follow the rules of IRC Section 72 (or specifically, IRC Section 72(e)(8)), which states (with respect to qualified plans) that taxable distributions will be treated as including a pro-rata share of any "investment in the contract" (i.e., cost basis, or after-tax contributions).


No further updates have been given in regard to how Fidelity and Vanguard now segregate and track the after tax accounts-So plans may allow it but they are not subject to repercussions of IRA conversions should IRS decide to close the loophole.

My understanding is that "the contract" under Section 72 can mean just the AT subaccount, assuming you have separate subaccounts.  Kitces article seems to either be dealing with an example where you have an AT account that is mostly earnings, or to a plan that doesn't have separate subaccounts at all.  More likely the latter, but it's really hard to say.  Note that he doesn't distinguish at any point between earnings on the AT contributions and earnings on the pretax contributions.

Here's an article dealing on the history behind separate subaccounts:
http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/separate-subaccount-treatment/

[brooklynguy]

I'm not a tax lawyer or accountant, but I think medinme's post above roughly translates into "the pro rata rule might very well be a problem for an in-service withdrawal of after-tax 401k funds into a private Roth account", and msilenus' response roughly translates into "well, the better argument is that it is not."

Am I correct?

When people who are obviously very intelligent and knowledgeable about these issues still can't reach consensus, and the benefit (to me) of this approach is marginal at best, my inclination may very well still be to scream "Controversy!  Uncertainty!  Run!"

[Undecided]

I'm not a tax lawyer or accountant, but I think medinme's post above roughly translates into "the pro rata rule might very well be a problem for an in-service withdrawal of after-tax 401k funds into a private Roth account", and msilenus' response roughly translates into "well, the better argument is that it is not."

Am I correct?

When people who are obviously very intelligent and knowledgeable about these issues still can't reach consensus, and the benefit (to me) of this approach is marginal at best, my inclination may very well still be to scream "Controversy!  Uncertainty!  Run!"

No, I don't think that's a fair summary. Better to say that msilenus's response points out that "the contract" referred to is medinme's response doesn't mean the entire 401(k) plan, but rather means any sub-account, and that failing to consider that distinction would lead to the wrong conclusion (that a withdrawal should be pro-rated across the entire 401(k), rather than only the applicable sub-account). That's consistent with the treatment recognized in the service ruling I linked you to before, in my opinion.

[brooklynguy]

No, I don't think that's a fair summary. Better to say that msilenus's response points out that "the contract" referred to is medinme's response doesn't mean the entire 401(k) plan, but rather means any sub-account, and that failing to consider that distinction would lead to the wrong conclusion (that a withdrawal should be pro-rated across the entire 401(k), rather than only the applicable sub-account). That's consistent with the treatment recognized in the service ruling I linked you to before, in my opinion.

Thanks, that is very helpful!

[ProfWinkie]

Interesting

[msilenus]

Basically correct.

I'm not a tax lawyer or accountant, but I think medinme's post above roughly translates into "the pro rata rule might very well be a problem for an in-service withdrawal of after-tax 401k funds into a private Roth account", and msilenus' response roughly translates into "well, the better argument is that it is not."

Am I correct?

When people who are obviously very intelligent and knowledgeable about these issues still can't reach consensus, and the benefit (to me) of this approach is marginal at best, my inclination may very well still be to scream "Controversy!  Uncertainty!  Run!"

No, I don't think that's a fair summary. Better to say that msilenus's response points out that "the contract" referred to is medinme's response doesn't mean the entire 401(k) plan, but rather means any sub-account, and that failing to consider that distinction would lead to the wrong conclusion (that a withdrawal should be pro-rated across the entire 401(k), rather than only the applicable sub-account). That's consistent with the treatment recognized in the service ruling I linked you to before, in my opinion.

That's going a smidge farther than I would.  I think Kitces is clearly making a case against this being illegal for someone.  The question is "who" and "why"?  He's talking about someone with 100k in "pretax" money and 20k in after tax.  I think the raw numbers there strongly suggest he's viewing pretax contributions as comingled with after-tax contributions, with pro-rata withdrawals --not a subaccount.  But why is the money comingled like that?  My main problem with reading the Kitces article as saying that you can't do this is that he's not really dealing with the possibility of separate subaccounts at all.

Indeed, because he doesn't get into that, the two readings don't even clearly conflict.  (This is what you're pointing out.)  You can reconcile the two articles entirely by simply positing that Kitces is talking about someone who doesn't have separate subaccounts, or someone who never made pretax contributions and septupled their money (a stretch, but possible), or is trying to write an article that doesn't assume such treatment.  I think the first and last are quite plausible.  He could also simply be ignorant of the mechanisms suggested based on separate subaccounts, but I don't want to assume that.

Incidentally, this same argument is playing out at Bogleheads.  Alan S is raising some other excellent points over there.

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=130961&newpost=2108908&start=50

[Undecided]

That's going a smidge farther than I would.  I think Kitces is clearly making a case against this being illegal for someone.  The question is "who" and "why"?  He's talking about someone with 100k in "pretax" money and 20k in after tax.  I think the raw numbers there strongly suggest he's viewing pretax contributions as comingled with after-tax contributions, with pro-rata withdrawals --not a subaccount.  My main problem with reading the Kitces article as saying that you can't do this is that he's not really dealing with separate subaccounts at all.

Indeed, because he doesn't get into that, the two readings don't even clearly conflict.  (This is what you're pointing out.)  You can reconcile the two articles entirely by simply positing that Kitces is talking about someone who doesn't have separate subaccounts, or someone who never made pretax contributions and septupled their money (a stretch, but possible), or is trying to write an article that doesn't assume such treatment.

Incidentally, this same argument is playing out at Bogleheads.  Alan S is raising some other excellent points over there.

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=130961&newpost=2108908&start=50

Apologies for putting words in your mouth.

[msilenus]

No worries!  I think drawing attention what was going on there in the meaning of the word "contract" was really important and useful.

[brooklynguy]

Based on everything I've read so far, it seems that a better summary of the risk involved than the one I offered previously is that doing an in-service withdrawal of funds in a post-tax 401k subaccount into a Roth IRA almost certainly raises no pro rata rule type issues (either with respect to (i) any traditional 401k subaccounts being left in place or (ii) any existing traditional IRA accounts), but there is a remote risk that the IRS could take a different view because no specific IRS guidance or case law exists that is directly on point.  Is that a fair summary of the lay of the land?

If so, is there any reason to think that rolling over the entire post-tax 401k subaccount balance into a Roth IRA upon termination of employment (rather than doing in-service withdrawals) is any less risky (for those of us who are still intimidated even by the remote involved)?  (Of course, doing it this way has the disadvantage of having to pay taxes on any earnings between the time of contribution and time of termination of employment.)

[msilenus]

That's how I read it.  IANAL, of course. :D

I have no opinion on the rest.  If you review the Kitces article, he goes into a way that some people have suggested you can do this after separation using a non-trustee rollover, but it's a fundamentally different mechanism with its own legal caveats (per Kitces) and I'm not sure if it carries more, less, or equal risk of the IRS taking a dim view of it.