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Suppose

  • In tax year t, I contribute 10000 to a Roth 401k and 10000 to an after tax 401k.
  • By tax year t+1, both amounts have grown by 10000 to 20000.
  • In tax year t+1, I convert the full 20000 from the after-tax 401k to the Roth 401k, paying applicable taxes on the 10000 earnings.
  • In tax year t+2 I rollover the entire 40000 into a Roth IRA.

Then

  • Does the 5 year rule apply on the After-tax 401k -> Roth 401k -> Roth IRA conversion of the 20000 (including 10000 earnings that was originally pre-tax)?

    • If so, what is the 5 year period? (5 years from Jan 1 of original conversion tax year?)

  • How does this affect Roth IRA withdrawal ordering rules with respect to the taxable portion of a single conversion being withdrawn before the non-taxable portion?

    • The entire 40000 rollover was non-taxable, post-tax money coming into the Roth IRA, but is the nature of the taxable after-tax 401k earnings -> Roth 401k conversion retained?
    • How does this affect taxes + penalties on withdrawals from the Roth IRA?

Assume that in-plan conversions and rollover from Roth 401k are permitted by the employer plan rules.

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  • Just going to take a stab here. There may be a benefit to opening the Roth IRA now with $1 in it. The thinking there is that the initial Roth IRA contribution starts the clock, and subsequent conversions won't reset it. But I think there are 2 different 5 year rules I may be mixing together. Somebody please set me straight on this.
    – TTT
    Dec 29, 2015 at 22:46
  • @TTT you are indeed mixing two 5 year clocks.
    – littleadv
    Dec 30, 2015 at 7:42
  • @littleadv - yeah- I figured. Thanks for clarifying. Your answer straightened me out.
    – TTT
    Dec 30, 2015 at 16:17

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Does the 5 year rule apply on the After-tax 401k -> Roth 401k -> Roth IRA conversion of the 20000 (including 10000 earnings that was originally pre-tax)?

No. The after-tax amounts are not subject to the 5 years rule. The earnings are.

How does this affect Roth IRA withdrawal ordering rules with respect to the taxable portion of a single conversion being withdrawn before the non-taxable portion?

Taxable portion first until exhausted.

To better understand how it works, you need to understand the rationale behind the 5-year rule.

Consider you have $100K in your IRA (traditional) and you want to take it out. Just withdrawing it would trigger a 10K statutory penalty, on top of the taxes due. But, you can use the backdoor Roth IRA, right? So convert the 100K, and then it becomes after-tax contribution to Roth IRA, and can be withdrawn with no penalty. One form filled ad 10K saved.

To block this loophole, here comes the 5 years rule: you cannot withdraw after-tax amounts for at least 5 years without penalty, if the source was taxable conversion. Thus, in order to avoid the 10K penalty in the above situation, you have a 5-year cooling period, which makes the loophole useless for most cases.

However amounts that are after tax can be withdrawn without penalty already, even from the traditional IRA, so there's no need in the 5 years cooling period.

The withdrawal attribution is in this order:

  1. Roth IRA contributions
  2. Conversions and rollovers (excluding Roth IRA rollovers), starting with the earliest, taxable portion first
  3. Earnings

Roth IRA rollovers are sourced to the origin. E.g.: if you converted $100 to the Roth IRA at firm X and then a year later rolled it over to firm Y - it doesn't affect anything and the clock is ticking from the original date of the conversion at firm X.

5-year period applies to each conversion/rollover from a qualified retirement plan (see here). Distributions are applied to the conversions in FIFO order, so in one distribution, depending on the amounts, you may hit several different incoming conversions. The 5 years should be check on each of them, and the penalty applied on the amounts attributable to those that don't have enough time.

5-year period for contributions applies starting from the beginning of the first year of the first contribution that established your Roth IRA plan.

The penalty applies to the amounts that were included in your gross income when conversion occurred, i.e.: doesn't apply on the amounts converted from after-tax sources.

Note the difference from the traditional IRA - distributions from pre-tax sources are prorated between the non-deductible (basis) amounts and the deductible/earnings amounts (taxable). That is why the taxable amounts are first in the ordering of the distributions.

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  • So, clarification on the earnings from the after-tax 401k: I pay marginal income tax on the 10k upon conversion from after-tax 401k to roth 401k. This starts a 5 years clock from Jan 1 of the tax year in which the conversion happened. Even if this converted amount is rolled over from a Roth 401k to a Roth IRA, the clock stays the same and, if a distribution withdraws any part of the original after-tax 401k money before the 5 year clock runs out, there will be penalties since taxable before non-taxable.
    – arcyqwerty
    Dec 30, 2015 at 16:16
  • So, in the example, the clock starts Jan 1 t+1 and ends Jan 1 t+6. As far as ordering rules go, 10k of the Roth IRA is now contribution (no tax/penalty), 10k is taxable conversion (no tax, penalty if before t+6), 10k is non-taxable conversion (no tax, no penalty), 10k is earnings (tax + penalty), distributed in that order.
    – arcyqwerty
    Dec 30, 2015 at 16:17
  • And if there were multiple conversions into the Roth 401k, that order is maintained when rolling over to Roth IRA even though ordering doesn't matter for Roth 401ks.
    – arcyqwerty
    Dec 30, 2015 at 16:19
  • The conversion clock starts on the day of the conversion. The contribution clock starts on Jan 1st of the year of the first contribution. Otherwise, yes, you got it
    – littleadv
    Dec 30, 2015 at 16:36
  • I'm not sure that the latter part regarding the contribution clock lines up with my understanding. To clarify, 26 CFR 1.408A-6 seems to suggest that "the distribution is made within the 5-taxable-year period beginning with the first day of the individual's taxable year in which the conversion contribution was made. The 5-taxable-year period ends on the last day of the individual's fifth consecutive taxable year beginning with the taxable year described in the preceding sentence." Am I misinterpreting that?
    – arcyqwerty
    Dec 30, 2015 at 16:52

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