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Financial Advice

Now's the Time to Consider a Roth Conversion of Aftertax Money

Take advantage of this loophole before proposed legislation takes it away at the end of the year.

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While the battle rages in Washington over which taxes to raise and which estate planning devices to kill, there is one loophole that is almost certainly going to be closed soon--by the end of this year if the current version of the bill passes: The Roth "conversion" of aftertax money in retirement accounts. Nobody is lobbying to save this little wealth-builder that should never have existed in the first place.

Not many people have aftertax money in their IRAs or 401(k) accounts. Among those who do, some don't have enough to bother with, and others will not be able to convert it to Roth status separately from the account's pretax money. But anyone who has a worth-bothering-with amount of aftertax money in an IRA or employer plan may want to take action (if possible) to convert that aftertax money to a Roth IRA while you still can.


Roth IRAs were invented in 1998 as a way to allow low/middle-income workers to make their annual IRA contributions to a retirement account that would grow tax-free (not just "tax-deferred" like regular IRAs). No deduction would be allowed for the contribution but (subject to minimal requirements), all future growth would be tax-free. And there would be no required minimum distributions for life. The worker could even "convert" an existing traditional IRA to a Roth IRA; the conversion amount would be taxed as if the money had been distributed to the converter.

Needless to say, the bonanza of tax-free investment growth, with no required distributions during life, was a luscious temptation for wealthy investors--but they were barred from both annual contributions and conversions by the income limits. Then the income limit bar for conversions was removed in 2010, and tax-savvy investors immediately starting doing Roth conversions.

Why did Washington decide to give wealthy investors a pathway to almost perpetual, unlimited, totally tax-free investment returns? Congress was apparently hungry to collect the immediate income tax flow resulting from Roth conversions. The heck with tomorrow, let some distant future administration worry about the loss of revenue from those tax-free Roth accounts decades from now!

Whether that was good policy can be debated, but one feature of the Roth conversion scenario was and is totally inexplicable: Nothing in the tax code prevented people from converting the aftertax money in their retirement plans to Roth status. Conversion of aftertax money generates no current revenue for the government, the supposed goal of allowing conversions in the first place.

If someone converted a little bit of aftertax money along with a big chunk of pretax money in his or her account, OK, at least the government is collecting some taxes. And yet, inexplicably, the IRS in 2014 blessed the separate conversion of only the aftertax money in employer plan accounts, and provided a road map for how to do just that!

'Build Back Better' Would Eliminate the Conversion of Aftertax Money

Congress has finally noticed this tax code flaw. Section 138311 of the proposed "Build Back Better" legislation would eliminate the Roth conversion of aftertax money in any type of retirement plan for individuals of all income levels starting in 2022. Any client who has aftertax money in any type of defined-contribution plan account or IRA should determine whether it can be converted to Roth status before the end of this year. Other than the complications of carrying out the conversion (see below) there is no downside to this move, though presumably the complications are worth incurring only if the amount of aftertax money is worth worrying about. Unfortunately, as the discussion below will show, not everyone with aftertax money in a retirement account will be able to take advantage of the convert-it-separately idea.

If the Aftertax Money Is in a Qualified Plan

Most people do not have any aftertax money in their employer retirement plans. Some who do:

  • An older client who has been working for the same company for many years may have an "employee contribution account" from contributions made years ago. Such an account contains the employee's contributions (aftertax money, also called "basis") and the growth thereon (the "earnings"), which is pretax money.
  • Aware of the attractive loophole of converting aftertax money, more employers have been permitting employees to top up their annual plan additions with voluntary aftertax contributions to such an employee contribution account.
  • Rarely, an employee who borrowed money from a retirement plan without fully complying with plan-loan limits and rules will have aftertax money in the plan as a result of the defective loan having been treated as a taxable distribution (even though it was repaid).

Note: We are not talking here about "designated Roth accounts." Those are already Roth accounts and don't need to be converted. We are talking about aftertax money in "traditional" employer plan accounts.

If the employee is entitled to take a distribution from the account in question (because she has retired or because the plan permits in-service distributions), the employee should request a distribution of the entire account that contains the aftertax money (normally, the employee contribution account). Because this is a distribution of the entire account, it will contain both aftertax money (the employee's contributions) and pretax money (the earnings on those contributions). In 2014, the IRS provided a road map of exactly how to do a tax-free Roth conversion of only the aftertax money when such a distribution occurs, in other words, how to separate the "cream" (the aftertax money) from the "coffee" (the earnings): The employee sets up a traditional IRA and a Roth IRA, then directs the plan administrator to send the pretax money to the traditional IRA and the aftertax money to the Roth IRA. See IRS Notice 2014-54, 2014-41 IRB, Part V, Example 4. Presto, the employee now has created a Roth IRA without owing any tax on the conversion.

The client may ask, "Why do I have to distribute the entire account? Why can't I just distribute the aftertax money?" Because every distribution must contain proportionate amounts of pre- and aftertax money; this is nicknamed the "cream in the coffee rule." You can't distribute them separately, but when a distribution occurs, you can send the two types of money contained in that distribution to different destinations. Don't expect these rules to make sense--I'm just telling you how it is!

For any such qualified plan situation, consult the plan administrator and an expert tax advisor to make sure exactly what the client can do and how to do it.

If the Aftertax Money Is in a Traditional IRA

If the client's aftertax money is in a traditional IRA, it will not be possible to convert it to a Roth separately from the pretax money in most cases. Such conversions are possible in only in two situations. Why? Because generally all distributions from an IRA are deemed to consist proportionately of the pre- and aftertax money in not just the particular IRA from which the distribution is made but all of the client's traditional IRAs collectively. No matter how many IRAs the client has, and no matter which account he actually made his aftertax contributions to, a distribution from any of his IRAs is deemed to be a distribution from all of them combined.

For many clients, the aftertax portion will just be a tiny percentage of the total collective values of all his IRAs, so any Roth conversion will be tax-free only to the extent of that same very tiny percentage. For example, if the client's IRAs collectively are worth $1 million of which only $10,000 (1%) is aftertax money, only 1% of any conversion will be deemed a tax-free conversion of aftertax money, regardless of which account the distribution comes from and regardless of which account actually received the aftertax contributions.

Here are the two exceptions, and these are the clients who should be contacted about this before the end of 2021.

  • First is the well-known "backdoor Roth contribution." This is for a client who does not have any other traditional IRAs--an IRA newbie. The client wants to make an annual $6,000 IRA contribution for 2021 ($7,000 if over 50). Her high income and employer plan participation bar her from contributing directly to a Roth IRA and from making a tax-deductible contribution to a traditional IRA. So, she contributes $6,000/$7,000 to a traditional IRA (nondeductible), then immediately converts the IRA to a Roth IRA. Since the contribution was of aftertax money and hasn't had time to accrue any earnings, and since the client has no other IRAs that must be aggregated with this one, the conversion is tax-free. It was this maneuver that seems to have caught the eye of Congress, which finally noticed the folly of allowing tax-free Roth conversions.
  • The other situation is quite rare: The client has a traditional IRA that contains pre- and aftertax money and also participates in a qualified employer retirement plan that accepts IRA rollovers. This client can roll over (transfer) into the employer plan all of the pretax money in the IRA, while keeping the aftertax money in the IRA. After the transfer, the IRA is 100% aftertax money, and the client converts it to a Roth IRA tax-free.

This works because, since qualified plans are forbidden by the tax code to accept aftertax money in a rollover from an IRA (why? I don't know), the tax code had to create an exception to the cream-in-the-coffee rule and allow the separation of basis and earnings in this situation. For this strategy to work, there is one other important rule: Do not have any rollover back in to an IRA for this client in the same taxable year as the Roth conversion! Doing so would totally dilute the Roth conversion and make it substantially taxable.

If the Build Back Better legislation goes through, the Roth conversion of aftertax money is almost certainly a goner. For those few clients who are in a position to take advantage of this loophole, do it now or (maybe) never!

Natalie Choate is a lawyer in Wellesley, Massachusetts, who concentrates in estate planning for retirement benefits. The 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is available through her website,, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article do not necessarily reflect the views of Morningstar.

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