Moving 401(k) funds

Karin Price Mueller/The Star-Ledger  writes: Question. Upon retirement, I rolled my pre-tax money from my 401(k) into an IRA. However, there seems to be some controversy about moving after-tax money from a 401(k) into a Roth IRA. My financial adviser says that the IRS has not yet ruled on this and his company advises against it, as they feel that the IRS will eventually rule against it. What is your opinion?

Answer. It’s ugly, but your adviser is probably correct.  "There has been much discussion around this topic and many creative strategies developed to attempt to get around the IRS position," said Diahann Lassus, a certified financial planner and certified public accountant with Lassus Wherley in New Providence. "However, based on recent guidance issued by the IRS in their IRS Notice 2009-68, it pretty much states that you can’t move the after-tax money from a 401(k) to a Roth IRA without tax consequences."

She said distributions from employer retirement plans follow the rules of IRC Section 72(e)(8), which states that taxable distributions will be treated as including a pro-rata share of cost basis or after-tax contributions.

"This means that when you take a distribution from a 401(k), the taxable portion is allocated so that you can’t really separate the pre-tax and the after-tax contributions," she said. "If you transfer the ‘after-tax’ portion of your 401(k) to a Roth IRA and your ‘pre-tax portion’ to a regular IRA, you will end up paying taxes on the Roth conversion for some portion of the Roth IRA dollars."

Lassus offers this example: Assume you have a $100,000 401(k) with $20,000 of after-tax contributions. You roll over the $80,000 to a regular IRA and the $20,000 to a Roth IRA. The rollover IRA would include 80 percent of the basis or $16,000 of the $20,000. She said the Roth IRA would include 20 percent of the basis or $4,000. This means that $20,000 minus $4,000, or $16,000, of the rollover to the Roth will be taxable.

Although there are open questions in this area, Lassus said the IRS position is relatively clear since the issuance of IRS Notice 2009-68. You should also consider that if the IRS did contest the transaction, and the timeframe for being able to recharacterize the IRA from a Roth back to a regular IRA had passed, there could be both tax consequences and potentially penalties and interest for you. The statute of limitations for the IRS to question the transaction is longer than the time horizon to recharacterize a Roth conversion.