Question on Roth 401k in plan conversion of after tax contributions

[dogboyslim]

I’m hoping not to have to hire a tax attorney on this.  I’ve never been able to do a mega backdoor Roth because I have a very large traditional IRA balance, so I’d trigger the aggregation rule that prorates the pre-tax and after tax amounts and creates a tax liability on the bulk of the conversion amount. 

I now work for a new company that will do in-plan conversions of after tax 401k contributions to the Roth 401k.  This would let me put an additional 20k into Roth 401k to max at 50k for the year, which is less than the total contribution limit.  As far as I can tell, the pro-rata rule ignores all company fund balances, so does that mean if I do this that it’s all within the company fund so I won’t get dinged with the pro-rate rule?  I couldn’t find anything on these anywhere in my initial search of the web or the IRS site.  Anyone here know the answer or can help point me in the right direction?  Thanks!

[seattlecyclone]

I’m hoping not to have to hire a tax attorney on this.  I’ve never been able to do a mega backdoor Roth because I have a very large traditional IRA balance, so I’d trigger the aggregation rule that prorates the pre-tax and after tax amounts and creates a tax liability on the bulk of the conversion amount. 

...not if you move your money directly from your after-tax 401(k) to your Roth IRA without a pit stop in your traditional IRA on the way.

I now work for a new company that will do in-plan conversions of after tax 401k contributions to the Roth 401k.  This would let me put an additional 20k into Roth 401k to max at 50k for the year, which is less than the total contribution limit.  As far as I can tell, the pro-rata rule ignores all company fund balances, so does that mean if I do this that it’s all within the company fund so I won’t get dinged with the pro-rate rule?  I couldn’t find anything on these anywhere in my initial search of the web or the IRS site.  Anyone here know the answer or can help point me in the right direction?  Thanks!

I believe the term of art you're looking for is "separate contracts." My understanding is it's possible for your company to set up its 401(k) plan in such a way that all the non-Roth balances are aggregated together and would therefore be prorated between pre-tax and post-tax in the event that you did a Roth conversion. It's also possible (and advantageous to you) for them to set up separate sub-accounts for your pre-tax and after-tax contributions so that conversions are kept separate. I'd like to believe that most companies that offer after-tax contributions know what's up and have configured their plan in the latter fashion. Find a coworker who has done the mega backdoor Roth and ask whether their conversions are largely non-taxable.

[dogboyslim]

Thanks for the reply @seattlecyclone , but I don't think I'm understanding.

I was not aware that I could move after-tax 401k contributions to a roth IRA without the pro-rata rule.  I thought it triggered for any conversion to a roth IRA.  I will look more into that.  That approach doesn't work for me though, because my company plan won't let me withdraw funds from the plan while employed, but I think it may be an option for my wife.

The second item
In my company 401k, there are 3 contribution options:  std 401k, money goes in pre-tax (this is where all match dollars go, as the company still doesn't offer roth 401k matches).  After-tax 401k contributions, and Roth 401k contributions.

I am income limited, so can't fund a Roth IRA.  I have a $1.4M standard IRA (from prior company pension/401ks), 67k in mixed roth 401k and match dollars.  This year they are adding the ability to do an additional 12% after-tax 401k contribution, and then do a daily sweep to convert in-plan, from the after-tax 401k into the roth 401k.  In this scenario, the IRAs never come into play as I understand it, so I don't think I have to worry about the conversions getting pro-rata mixed with the IRA.  Its the tax provisions behind this that I'm trying to find and confirm.  I did look up separate contracts, but that didn't get me what I was looking for, or perhaps I just wasn't smart enough to understand what I was reading.

Thanks!

[seattlecyclone]

I was not aware that I could move after-tax 401k contributions to a roth IRA without the pro-rata rule.  I thought it triggered for any conversion to a roth IRA.  I will look more into that.  That approach doesn't work for me though, because my company plan won't let me withdraw funds from the plan while employed, but I think it may be an option for my wife.

Pre-tax IRA balances are prorated with after-tax IRA balances when you convert from traditional IRA to Roth IRA. Moving money from 401(k) to Roth IRA is a different transaction entirely. Instructions for reporting this are in IRS Publication 575.

How to report. Enter the total amount of the distribution before income tax or deductions were withheld on Form 1040, 1040-SR, or 1040-NR, line 5a. This amount should be shown in box 1 of Form 1099-R. From this amount, subtract any contributions (usually shown in box 5 of Form 1099-R) that were taxable to you when made. Enter the remaining amount, even if zero, on Form 1040, 1040-SR, or 1040-NR, line 5b.

Note that these instructions do not require you to look up your pre-tax IRA balances.

The second item
In my company 401k, there are 3 contribution options:  std 401k, money goes in pre-tax (this is where all match dollars go, as the company still doesn't offer roth 401k matches).  After-tax 401k contributions, and Roth 401k contributions.

I am income limited, so can't fund a Roth IRA.  I have a $1.4M standard IRA (from prior company pension/401ks), 67k in mixed roth 401k and match dollars.  This year they are adding the ability to do an additional 12% after-tax 401k contribution, and then do a daily sweep to convert in-plan, from the after-tax 401k into the roth 401k.  In this scenario, the IRAs never come into play as I understand it, so I don't think I have to worry about the conversions getting pro-rata mixed with the IRA.  Its the tax provisions behind this that I'm trying to find and confirm.  I did look up separate contracts, but that didn't get me what I was looking for, or perhaps I just wasn't smart enough to understand what I was reading.

Here's another section of Publication 575 that talks about the possibility of "separate contracts" in a defined contribution plan.

Defined contribution plan. A defined contribution plan is a plan in which you have an individual account. Your benefits are based only on the amount contributed to the account and the income, gains or losses, etc., which may be allocated to that account. Under a defined contribution plan, your contributions (and income allocable to those contributions) may be treated as a separate contract for figuring the taxable part of any distribution. The employer contributions (and income allocable to those contributions) wouldn't be considered part of that separate contract.

Example. Ryan participates in a defined contribution plan that treats employee contributions and earnings allocable to them as a separate contract. He received a non-annuity distribution of $5,000 before his annuity starting date. He had made after-tax contributions of $10,000. The earnings allocable to his contributions were $2,500. His employer also contributed $10,000. The earnings allocable to the employer contributions were $2,500.
To determine the tax-free amount of Ryan's distribution, use the same formula shown earlier. However, because employee contributions are treated as a separate contract, the account balance would be the total of Ryan's contributions and allocable earnings.

Thus, the tax-free amount would be $5,000 × ($10,000 ÷ $12,500) = $4,000. The taxable amount would be $1,000 ($5,000 − $4,000).

If the employee contributions weren't treated as a separate contract, the tax-free amount would be $2,000 ($5,000 × ($10,000 ÷ $25,000)) and the taxable amount would be $3,000 ($5,000 − $2,000).

This shows that a partial withdrawal from your employer plan is prorated between pre-tax and after-tax amounts (similar to how a partial withdrawal from an IRA is prorated between pre-tax and after-tax amounts). But it introduces the concept of a "separate contract" that lets the plan put your money into different buckets that are prorated individually. In this example the employer puts the employer contributions in a "separate contract" from Ryan's after-tax contributions. In this case it means Ryan's withdrawal from their employee contributions contract is taxed less than it would have been if the employer contributions were grouped into that calculation.

Given that your plan seems to be set up specifically to let employees take advantage of the mega backdoor loophole, with daily automatic conversions and everything, I would bet almost anything that the employer did the right paperwork to make sure that these after-tax contributions are properly segregated into a separate contract from the rest of your 401(k) so that the pre-tax amounts don't ruin everything. It doesn't seem like it's technically required for every company to do it this way though.

[dogboyslim]

Thank you for your patience with me.  That was exactly what I was looking for.