Author Topic: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?  (Read 38298 times)

brooklynguy

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #100 on: January 08, 2015, 03:51:41 PM »
I've been researching this and came across this article:
http://thefinancebuff.com/after-tax-401k-403b-rollover-to-roth-small-paycheck.html

If you have this "Mega Backdoor Roth" option, and have outside investments already, and won't get
up to the 53k from your annual salary
, you can "convert" non-retirement money into Roth.  Basically use your outside investments to live off of, and put your whole paycheck to this.

The numbers he uses are not very mustacian, but there's still benefit IMO.

That's not exactly right.  If you won't get up to the $53k from your annual salary, then there's no way to get that much into the 401k to do the rollover in the first place.  What this article is saying is very simple -- if you want to take advantage of the mega back door roth to the fullest extent possible, but can't because you won't have enough of your paycheck leftover to live on, then just live on your preexisting assets instead of your paycheck to allow you to do the mega backdoor roth.

But the comments to this article alerted me to a new IRS FAQ on the megabackdoor roth strategy that, at first blush, is very troubling.  According to the KPMG link in the comments to that article, this is from the IRS FAQ:

Quote
Can I roll over just the after-tax amounts in my account to a Roth IRA and leave the remaining amounts in the plan (i.e., take a partial distribution of just the after-tax amounts)?

No. The guidance provided in Notice 2014-54 does not alter the requirement that each distribution from a plan must include a proportional share of the pretax and after-tax amounts in the account. Accordingly, any partial distribution from the plan must include some of the pretax amounts you have in your account -- you cannot take a distribution of only the after-tax amounts and leave the pretax amounts in the plan. In order to roll over all of your after-tax contributions to a Roth IRA, you could take a distribution of the full amount (all pretax and after-tax amounts) in your account, roll over all the pretax amounts in a direct rollover to a traditional IRA or another eligible retirement plan, and roll over all the aftertax amounts in a direct rollover to a Roth IRA.

At first blush, this seems to run counter to the mega back door roth strategy.  I'm about to leave the office and won't be able to research this or give serious thought to it until later tonight at the earliest, but a quick google search didn't turn up anything.

Seattlecyclone or any of the other tax buffs, do you care to weigh in on this?

MrMoogle

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #101 on: January 08, 2015, 05:21:22 PM »
Yes I mispoke and you said it much better, thanks for clearning that up :)

So about the IRS FAQ, here is how I understand it.
For in-service distributions, you can't pull out tax-advantaged funds, so if you do it in-service you take out post-tax and post-tax earnings.  And if you have 20% earnings, and take out $1000, then $200 is earnings and $800 is contribution. 

Now after you've left the company, and want to take out $1000, and you have 50% pre-tax, 40% post-tax and 10% post-tax earnings, it has to be $500 pre-tax, $400 post-tax, and $100 post-tax earnings. 

Either way, as long as you do it all at one time, you can now, thanks to the new rule, send each part to a different location.  Pre-tax can go to a tIRA, post-tax to Roth IRA, and post-tax earnings to tIRA.  But you have to specify (somehow) that the post-tax is going to Roth IRA, not just $400 is going there.  Before if you sent $400 to a Roth IRA, only 40% would be from the post-tax.

seattlecyclone

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #102 on: January 08, 2015, 05:24:14 PM »
My understanding is that if your 401(k) plan is structured so that you have sub-accounts for each funding source (pre-tax, after-tax, Roth, etc.), you are allowed to choose to withdraw funds from whichever sub-account you wish without affecting the other sub-accounts one bit.

If my understanding is correct, what I hope the IRS means is that you can't choose to make a withdrawal from the the after-tax sub-account of your 401(k) that includes only contributions. If you have $4,000 of contributions and $1,000 of earnings sitting in that sub-account, you may not choose to only withdraw the $4,000 of contributions. If you did withdraw only $4,000, it would be considered a withdrawal of $3,200 of contributions and $800 of earnings. Once you withdraw the $4,000, you are free to put the $3,200 in your Roth IRA and $800 in your traditional IRA and pay no tax, but just leaving the earnings where they are is a no-no.

skyrefuge

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #103 on: January 08, 2015, 07:06:17 PM »
Quote
Can I roll over just the after-tax amounts in my account to a Roth IRA and leave the remaining amounts in the plan (i.e., take a partial distribution of just the after-tax amounts)?

No. The guidance provided in Notice 2014-54 does not alter the requirement that each distribution from a plan must include a proportional share of the pretax and after-tax amounts in the account. Accordingly, any partial distribution from the plan must include some of the pretax amounts you have in your account -- you cannot take a distribution of only the after-tax amounts and leave the pretax amounts in the plan. In order to roll over all of your after-tax contributions to a Roth IRA, you could take a distribution of the full amount (all pretax and after-tax amounts) in your account, roll over all the pretax amounts in a direct rollover to a traditional IRA or another eligible retirement plan, and roll over all the aftertax amounts in a direct rollover to a Roth IRA.

At first blush, this seems to run counter to the mega back door roth strategy.

I haven't been following this nearly as closely as you guys, but it appears like a giant roadblock to me too. Kitces mentions it twice in his post:
https://www.kitces.com/blog/irs-notice-2014-54-acquiesces-on-splitting-after-tax-401k-contributions-for-roth-conversion/
Quote from: Kitces
Notably, to the extent a retiree takes out only part of the account, the pro-rata rules under IRC Section 72(e)(8) do still apply to determine how much is coming out in the first place. Thus, for instance, if the 401(k) balance is $100,000 including $20,000 of after-tax funds, and the individual only requests a $20,000 distribution, then the distribution is treated as $16,000 of pre-tax and $4,000 of after-tax; while this could still be split, with the $16,000 of pre-tax to a rollover IRA and $4,000 of after-tax to a Roth, if the account owner wants to get out all $20,000 of after-tax funds into a Roth, he/she will be required to take all $100,000 from the 401(k) plan getting out the whole $20,000 of after-tax and $80,000 of pre-tax and can then allocate the pre-tax funds to a rollover IRA and the after-tax to a Roth.

All the Examples in IRS 2014-54 (http://www.irs.gov/pub/irs-drop/n-14-54.pdf ) seem to support this view too.

Neither source mentions anything about seattlecyclone's idea of "sub-accounts" that can be withdrawn from individually, though I have seen references to 401(k) plans that allow such sub-account withdrawals, and there are people in page 4 of the bogleheads thread (https://www.bogleheads.org/forum/viewtopic.php?f=2&t=137366&start=150 ) who believe such legal separation is possible. I guess my interpretation of 2014-54 is that it explicitly disallows such sub-account withdrawals, and tells 401(k) plans "no, you can't actually do what you've been doing". But it seems like some of those bogleheads have dug deeper into the legalese than me, so my answer is probably still "who knows?" I think I'm just glad I can't do after-tax contributions of any sort in my plan so I don't have to be worried/tantalized. :-)

seattlecyclone

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #104 on: January 08, 2015, 07:25:25 PM »
The legal separation is often referred to in IRS publications as a "separate contract" (since 401(k) and similar plans are covered under the section of law that deals with pensions and annuity contracts). One example is this section of publication 575. This publication explains that if the employee's plan decides to structure employee contributions as a separate contract from employer contributions, the pro-rata taxable share of withdrawals can be lower than if the plan structured things as all one big "contract" where employee contributions were mixed with employer contributions.

Other sections of that same IRS publication describe how a plan can have the Roth portion of a 401(k) plan separated out as a "separate contract" from the pre-tax portion. The fact that it is structured as a separate contract means that you can withdraw from the Roth portion tax-free without being considered to have withdrawn a proportional amount from the pre-tax "contract" under your plan.

My own employer has an internal financial planning mailing list. Dozens (hundreds?) of these people have been regularly making these after-tax contributions and rolling them over to Roth IRAs. Some of them have been doing this for several years. I have not heard of one of them posting back that they got in trouble for rolling over only the after-tax sub-account without pro-rating their withdrawal across their pre-tax sub-account as well. This is of course not perfect proof, but it's good enough for me.

brooklynguy

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #105 on: January 08, 2015, 08:07:21 PM »
I'd like to mull this over some more and do additional research, but as of now I think seattlecyclone's interpretation is the only reasonable reading of the FAQ, since it is impossible to accompany an in-service withdrawal from an after-tax subaccount with a withdrawal from a traditional pre-tax subaccount.  But it is unfortunate that the IRS chose to use such unclear language in what was intended to be a clarification of Notice 2014-54, which I don't think needed clarifying in the first place.  This will lead to more confusion, not less.

Skyrefuge - I'm very glad to see you joining the brain trust on this issue.

Alan S. in the boglehead forums (one of the blogosphere's leading authorities on these matters) has noted that the Kitces commentary seems to be ignoring subaccounts in his thread about Notice 2014-54, which is incidentally the only other place on the internet I've been able to locate with any discussion about the new FAQ (besides the original financebuff article that MrMoogle linked to above):

https://www.bogleheads.org/forum/viewtopic.php?f=2&t=147196

skyrefuge

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #106 on: January 08, 2015, 10:10:17 PM »
Ok, I'm sufficiently convinced (for someone who doesn't have to make this decision himself!) that this "separate contract/sub-account" is an actual IRS-allowed thing. It just feels weird that this artificial separation is respected in the 401(k) world, because in the IRA world, the IRS gives zero fucks about whether you have your IRAs in "separate contracts": "nice try, asshole, you thought you could trick me by holding your money in separate accounts? Get the hell out of here, it's all one pot!" But I guess the different treatment of 401(k)-vs.-IRA is just another highlight of what a jury-rigged mess the whole 401(k) concept is!

However, knowing that "separate contracts/sub-accounts" is IRS-allowed is just the first (or, eleventh?) step. There's still the question of whether your employer's plan is legally structured that way. For his part, Kitces doesn't seem to think it's terribly common: "Anecdotally, I find that many/most end out doing it all in one account, probably to save on administrative costs for tracking two accounts, but it does vary by plan/employer."

On the other hand, Fairmark believe that "Recordkeeping systems now in use should handle this feature easily", but does not give an opinion on how frequently this feature is taken advantage of by employers.

Fairmark also has a page dedicated to clearly describing the legal basis for the "separate contract/sub-account" theory: http://fairmark.com/retirement/roth-accounts/roth-conversions/isolating-basis-for-roth-conversion/separate-subaccount-treatment/

MrMoogle

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brooklynguy

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #108 on: January 09, 2015, 05:59:32 AM »
Ok, I'm sufficiently convinced (for someone who doesn't have to make this decision himself!) that this "separate contract/sub-account" is an actual IRS-allowed thing. It just feels weird that this artificial separation is respected in the 401(k) world, because in the IRA world, the IRS gives zero fucks about whether you have your IRAs in "separate contracts": "nice try, asshole, you thought you could trick me by holding your money in separate accounts? Get the hell out of here, it's all one pot!" But I guess the different treatment of 401(k)-vs.-IRA is just another highlight of what a jury-rigged mess the whole 401(k) concept is!

When I first about the mega backdoor Roth early last year, my first concern was that since it is the 401(k) analog to the IRA world's regular backdoor Roth, there should be an analog to the pro-rata rule that would apply to any traditional pre-tax 401(k) contributions.  As you said, from a logical and policy perspective, there's no reason why there should be a pro-rata issue in the IRA world but not the 401(k) world.  I raised this concern in this old thread, but the general consensus of the tax cognoscenti was that that's indeed how it works (notwithstanding how illogical it is) and that the risk of the IRS taking a contrary view was remote.  That was before the issuance of Notice 2014-54, in which the IRS seemingly explicitly threw in the towel on reserving any objections to this approach.

MrMoogle

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #109 on: January 09, 2015, 03:41:13 PM »
So I asked Vanguard specifically about my 401k, here's my rep's response:

"Your plan does have an After-tax distribution option, which you may roll
over to an IRA. You are correct that you may roll over the pure after-tax
money into a Roth IRA and the earnings (pre-tax money) into a traditional
IRA. The process is not difficult and Vanguard associates will be glad to
assist you when you are ready to do this. There are no fees for an
After-tax withdrawal and no limit for the frequency of this type of
withdrawal.

As of January 8, 2015, you may request an After-tax withdrawal of up to
$XX ($YY taxable). If you would like to request a withdrawal,
please call us at the number below and an associate will be happy to assist
you. This transaction cannot be completed online."

So they don't have a problem performing the in-service distribution, although I guess technically they didn't mention tax implications.

Mississippi Mudstache

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #110 on: March 05, 2015, 07:38:27 AM »
I just realized that my 401k allows for in-service withdrawals, so I came back to thread to read up on the topic. Last year, I made two months' worth of after-tax contributions after hitting the pre-tax maximum in October. I'm about to contact my plan administrator, and I'm crossing my fingers that I'll be able to withdraw just the after-tax contributions.

If it works out, this could be a huge boost in getting my Roth IRA filled up in preparation for ER without incurring unnecessary income taxes in the meantime. I guess I'll just have to figure out how to earn more/spend less, because $18,000 in my 401k + $6650 in my HSA + $11000 in our traditional IRAs is all I'm projecting that I'll be able to save this year.
« Last Edit: March 05, 2015, 07:40:10 AM by Mississippi Mudstache »

brooklynguy

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #111 on: March 05, 2015, 07:48:55 AM »
I just realized that my 401k allows for in-service withdrawals, so I came back to thread to read up on the topic. Last year, I made two months' worth of after-tax contributions after hitting the pre-tax maximum in October.

Why did you make after-tax 401k contributions without a view towards doing mega backdoor roth rollovers?  Simply for the tax deferral on the earnings?

This reminds me that it's time to follow up on the status of bearkat's hiccup in executing his mega backdoor rollover...

seattlecyclone

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #112 on: March 05, 2015, 07:52:37 AM »
I just realized that my 401k allows for in-service withdrawals, so I came back to thread to read up on the topic. Last year, I made two months' worth of after-tax contributions after hitting the pre-tax maximum in October. I'm about to contact my plan administrator, and I'm crossing my fingers that I'll be able to withdraw just the after-tax contributions.

You can't withdraw just the contributions. Any earnings have to come out as well. You are allowed to divert the earnings to a traditional IRA to avoid paying tax on them for now (which could probably be rolled back into your 401(k) if you really felt like it), but you can't just leave that amount in your after-tax 401(k) subaccount.

Mississippi Mudstache

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #113 on: March 05, 2015, 07:55:24 AM »
Why did you make after-tax 401k contributions without a view towards doing mega backdoor roth rollovers?  Simply for the tax deferral on the earnings?

Good question. I actually changed employers in October after having already hit the $17,500 with my old employer. I made after-tax contributions so I could still receive the 6.6% match that my new employer offers.

You can't withdraw just the contributions. Any earnings have to come out as well. You are allowed to divert the earnings to a traditional IRA to avoid paying tax on them for now (which could probably be rolled back into your 401(k) if you really felt like it), but you can't just leave that amount in your after-tax 401(k) subaccount.

Right. That won't be a problem - I already have traditional and Roth IRAs open at Fidelity. I have about $4,000 in pre-tax 2015 contributions right now, and I'll just as soon leave them in the 401k. But I won't have a problem moving them if it's my only option.
« Last Edit: March 05, 2015, 07:57:14 AM by Mississippi Mudstache »

michaelrecycles

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Re: Did the IRS just give an extra $35k/yr of tax-free-growth saving space?
« Reply #114 on: March 13, 2015, 02:18:11 AM »
Thank you all who contributed to this thread (as well as the Mad Fientist). I was wondering what to do once I max out the pre-tax portion. After reading this thread and confirming my plan allows it, I now have a strategy.