I am converting after-tax 401-k to Roth 401-k. Is converting a portion this tax year and the rest next tax year to spread out the tax burden allowable/smart?

[mdgallaghermd]

I will have to pay income tax on the capital gains when I convert after-tax to Roth 401-k.  Is there a reason that I should or should not convert a portion this tax year and the rest next tax year to spread out the tax burden?

[Critter]

You must mean PRE TAX 401K conversions ... and you usually cannot convert from a 401K to a Roth 401K (ask your employer) ... so do you mean you will convert to a ROTH IRA ?  

And yes, the converted amount will be taxable in the year of conversion so the timing of how much and when could make a difference.  You may wish to discuss this with a financial planner or a tax preparer  to figure out the options.

[SweetieJean]

A conversion is taxed at ordinary income rates, niot capital gains rates.

[dmertz · Accepted solution]

[Revised]

The taxable amount of an In-plan Roth Rollover adds to your ordinary taxable income for the year in which you do the In-plan Roth Rollover.  If the taxable amount is enough to push you into a higher tax bracket, it may be advantageous to spread the income out over a couple of years to reduce the overall tax burden, provided your plan allows periodic In-plan Roth Rollovers.  Of course, to be able to estimate your overall tax burden, you'll need to be able to make a reasonable guess at your taxable income for the years involved.

If the taxable portion will be taxed at the same rate either way, it would generally make sense to do the In-plan Roth Rollover all in the earlier year.  Any amount deferred to the next year will grow tax deferred instead of tax free until it is rolled to the Roth account, so on the assumption that investments will grow in value over the period, the sooner the better.  If you are considering doing this in 2016 and 2017, the time between the two separate rollovers could be as little as a few weeks since that's all we have left of 2016, so the intervening time shouldn't be much of an issue.

Don't forget to consider your state taxes in determining your overall tax burden.

Also note that an In-plan Roth Rollover is irrevocable.  If the value of your investments goes down, you will have paid tax on an amount greater than the future, lower value for the Roth account.  There is no possibility of recharacterizing as there would be with a rollover to a Roth IRA (which is likely not an option since you are presumably working for this employer).

One final thought.  Unless the after-tax contributions and their associated earnings are held in a separate sub-account from any pre-tax contributions and associated earnings, the after-tax portion and associated earnings cannot be distributed (rolled over) in isolation from the pre-tax contributions and associated earnings.  The taxable proportion would instead be calculated in proportion to the total balance rather than just that of the after-tax sub-account.

The following IRS web page may provide some additional useful information:

https://www.irs.gov/retirement-plans/designated-roth-accounts-in-plan-rollovers-to-designated-roth-a...

[SweetieJean]

It seems like OP is saying the following:
1. Wants to convert AFTER-TAX 401-k to Roth 401-k.
2. Will have "capital gains"
<a rel="nofollow" target="_blank" href="http://news.morningstar.com/articlenet/article.aspx?id=682209">http://news.morningstar.com/articlene...>

[dmertz]

Thanks, SweetieJean.  I'll take a few minutes and revise my answer since I missed that there is after-tax basis in the traditional 401(k).

[dmertz]

I've revised my answer to more clearly address the fact that a portion of the rollover will be nontaxable due to after-tax basis in the traditional 401(k) account.

[ass69057]

I have a follow-up question:

If you do an in-plan conversion from pre-tax or after-tax 401k to Roth 401k, then after the conversion, which portion would be treated as basis in Roth 401k?

Let's say you originally have 1k after-tax contribution, 0.7k earnings from after-tax contributions, 2k pre-tax contributions, 1.4k earnings from pre-tax contribution. And you roll-over everything into a empty Roth 401k.

Then, the resulting Roth 401k has how much basis and how much earnings? The number is importance when you do an early withdrawal from Roth 401k.

[dmertz]

The $5.1k moved to the Roth 401(k) by In-plan Roth Rollover (IRR) will consist of $4.1k that would be subject to a 10% early-distribution penalty if distributed before 5-years from the beginning of the year in which the IRR occurred and $1k that would be penalty-free no matter when it was distributed.  None of the amount moved to the Roth 401(k) in the IRR becomes earnings in the Roth 401(k).  Subsequent earnings within the Roth 401(k) would be taxable and subject to 10% early-distribution penalty if distributed early.  Nonqualified distributions consist of proportionately of taxable amounts (earnings in the Roth 401(k)) and nontaxable amounts (attributable to the IRR), with the $4.1k that was taxable in the IRR coming out before the $1k that was not taxable in the IRR.  So if there were no earnings in the Roth 401(k) after the IRR, the first $4.1k distributed would be subject to penalty if the distribution was made before the completion of the 5-year IRR holding period.  (See IRS Notice 2010-84.)  If there were earnings within the Roth 401(k), the distribution would be a mix of amounts subject to tax and penalty and amounts that are not taxable but may be subject to penalty.

If one wants to make a partial distribution from a Roth 401(k) and there have been earnings within the Roth 401(k), one normally first rolls the entire Roth 401(k) over to a Roth IRA and then makes a distribution from the Roth IRA to take advantage of the more advantageous ordering rules for Roth IRA distributions.  In the Roth IRA the $4.1k becomes basis in taxable Roth conversions with the 5-year IRR holding period carrying over from the Roth 401(k), the $1k becomes basis in nontaxable Roth conversions and the earnings within the Roth 401(k) become earnings in the Roth IRA.  The ordering rules for distributions from a Roth IRA dictate that the earnings come out last rather mixed with nontaxable amount as they would be if distributed from the Roth 401(k).  Keep in mind, though, that to roll money over to a Roth IRA you must be eligible to receive a distribution from the Roth 401(k).  Hardship distributions cannot be rolled over.

[ass69o57]

Thank you for your detailed reply!! It is really helpful.
The Roth 401k to Roth IRA conversion you described is especially interesting.
Can you point me to some reference that states the fact that when the rollover is completed the in-plan Roth conversion would still be treated as "conversions" in Roth IRA?
I looked up the "Retirement Plans FAQs on Designated Roth Accounts" on the IRS website, and it doesn't seem to mention this special situation.

[dmertz]

A-12 of IRS Notice 2010-84 (<a rel="nofollow" target="_blank" href="https://www.irs.gov/pub/irs-drop/n-10-84.pdf">https://www.irs.gov/pub/irs-drop/n-10-84.pdf</a>) implies that amounts rolled over from a Roth 401(k) to a Roth IRA have the same character as they had in the Roth 401(k):

"The 5-year recapture rule in this Q&A-12 does not apply to a distribution that is rolled over to another designated Roth account of the participant or to a Roth IRA owned by the participant; however, the rule does apply to subsequent distributions made from such other designated Roth account or Roth IRA within the 5-taxable-year period."

[ass69o57]

Thanks!!