Mega Backdoor Pro Rata Rules

[Larry Ragman]

I’ve read the previous posts on this site regarding mega Backdoor Roth rollovers but I am confused by the pro Rata rule. Hoping for some guidance from the forum before I pull the trigger on my first rollover.

Background: my employer contributions for our 403b plan go to a separate account that allows employee after tax contributions. I did so for the first time last year. This plan tracks the after tax contributions separately. It also allows the after tax contributions to be rolled over to a Roth IRA.

Assumption: I will roll 100% of these separately tracked after tax funds, which will include whatever “pretax” gain that accrued during the past year, to a Roth IRA. Some rough numbers for illustration - total pretax $500k, total after tax $25k and that includes $1k of gains.

Question: how is this rollover taxed? That is, does the pro Rata rule only apply to these funds, so that the after tax portion is much larger than the taxable gain (e.g., 1k/$25k is the taxable percentage)? Or, does the after tax rollover get combined with the whole pretax 403b account that stays behind, so that the percent of the transaction that is taxable becomes very high ($500k/$525k is the taxable percentage)?

Thanks in advance for your insights.

P.s., I don’t want to confuse the issue, but my plan also allows after tax contributions to the account with my employee contributions to the 403b. The employee portion allows direct conversion of the after tax contributions to an in plan Roth 403b, but the employer contribution account is not that flexible. These two plans are treated separately.

[Peds]

only tIRA, sepira, simpleira.

[jfoxcpacfp]

Only conversions from IRAs (including SEP and SIMPLEs as mentioned by @peds) to Roth IRAs are taxed under the pro-rata rule. The purpose of this rule is to prevent people from gaming the system by using nondeductible IRAs to move money into a Roth when they "should" first convert the pre-tax IRAs they already own. You will not owe any pro-rata taxes on your rollover.

[spiritrider]

If the after-tax contributions and earnings are separately accounted for, distributions from the after-tax account are pro-rata only on the after-tax contributions and earnings.

To make sure you do not confuse the issue, use clarifying terminology. While Roth contributions are technically after-tax contributions, you should always refer to these as designated Roth and/or post-tax to distinguish them from employee after-tax.

Are you truly referring to after-tax contributions to your employee deferral account or employee elective contributions to the designated Roth account. If it is the former, you would never want to make employee after-tax contributions to a pre-tax account, because that In-plan Roth Rollover (IRR) would be pro-rata with all distributable pre-tax balances

This would be extremely unusual, behavior that I have never seen. If a plan allows both employee after-tax contributions and IRRs, the after-tax contributions would only be to the after-tax account and the after-tax contributions and earnings would be rolled over to the after tax account.

Usually, but not always, if a plan offers employee after-tax contributions and an IRR from the after-tax account, they also allow in-service rollovers of the after-tax account. Also, they might allow an IRR from any distributable pre-tax amounts (rollover contributions and vested employer contributions).

After-all, the IRR was originally intended for the rollover of pre-tax amounts to the designated Roth account. Like many of the steps you can take with employee after-tax contributions, they are convenient byproducts of the intended use.

[spiritrider]

It is not entirely correct to say that rollovers of a 401k employee after-tax account are not subject to pro-rata rules. In the case of partial rollovers, they most definitely are. In the case of full rollovers, they effectively are. The difference between partial and full conversions/rollovers is a taxation distinction without a difference

I suppose it matters whether you are using the term pro-rata to refer to the effects on the remaining balances in a partial Roth conversion/401k rollover or the proportional taxation of the conversion/rollover.

1. When you do a partial Roth conversion of a traditional IRA account with both non-deductible contributions and pre-tax balances. The conversion is treated as coming proportionally from both the non-deductible and pre-tax balances, with only the pre-tax balances taxable.


2. When you do a partial rollover from a 401k employee after-tax account to a Roth IRA or Roth 401k account with both after-tax contributions and pre-tax earnings. The rollover is treated as coming proportionally from both the after-tax contributions and pre-tax earnings, with only the pre-tax balances taxable.


3. When you do a full Roth conversion of a traditional IRA account with both non-deductible contributions and pre-tax balances, only the pre-tax balances are taxable.


4. When you do a full rollover from a 401k employee after-tax account to a Roth IRA or Roth 401k account with both after-tax contributions and pre-tax earnings, only the pre-tax balances are taxable.

The only difference between a partial Roth conversion/partial employee after-tax account rollover to a Roth IRA or Roth 401k account and the associated full conversion/rollovers is what happens to the remaining non-deductible/after-tax and pre-tax balances.

The bottom line is that in all cases the taxation is proportional. The only relevant fact to the OP's question is whether the other pre-tax account assets are included for pro-rata treatment like with Roth conversions and the answer is no.

Edited for some cut and paste mostly grammatical errors that might have been confusing.

[Larry Ragman]

Thank you for a comprehensive view. I’ll have to reread several times for all the permutations, but my take away is that since the after tax contributions and gains are accounted for separately from the pretax contributions in the plan, any distribution of the after tax portion to the Roth will only consider the after tax contributions and gains for tax purposes.

[spiritrider]

Yes, that is correct even though there is language in an IRS reference on their website that is very confusing to the uninitiated. The key is to focus on the separate accounting of where the rollovers are coming from and not the plan as a whole.

[ProximalLADLesion]

Someone correct me if I'm wrong. My understanding is as follows:

There are two mechanisms that may or may not be available in a tax-deferred plan that are necessary for really taking advantage of the mega back door Roth option. The first is ability to make after-tax contributions, and the second is ability to make in-service rollovers.

After-tax contributions have already been taxed (as the name implies) and as such are eligible for rollover to a Roth IRA without paying additional tax. The catch is that earnings on after-tax contributions are subject to tax. This is why you really need the ability to do in-service rollovers. If you roll over the after-tax contributions rapidly into your Roth IRA, before they've had time to grow, then you don't really need to worry about tax, as it'll either be nothing or negligible. If, however, you wait for a while after making the contributions to roll them over to your Roth IRA, you'll be taxed on the earnings of the after-tax contribution.

[Larry Ragman]

Yes, and there are several good WCI posts on this aspect of the Mega Backdoor technique. The transaction approach you describe of moving the money rapidly works in the employee contributions portion of my 403b because there is an in plan Roth option that I can move after tax funds to each pay period. But my after tax contributions to the employer portion of the 403b plan are not as flexible.