Good news from the IRS! (yes I know this is strange that I am excited about this news)
First a bit of background on after-tax funds in an IRA. Suppose you have an IRA worth $500,000 of which $50,000 is after tax funds. Any distribution from the IRA would be a portion of after-tax and pre-tax, whether that distribution is a withdrawal or Roth conversion. For example if the IRA owner took out $10,000, 10% or $1,000 would be considered after-tax. For all practical purposes the pre-tax and after-tax amounts cannot be separated just like cream in a coffee; every sip is a bit of cream and some coffee. Some people who have made after tax contributions to an IRA have mistakenly assumed that they can simply convert that IRA to a Roth tax free however this pro-rata rule applies because all IRAs of the owner are considered one for this purpose.
Ok so here's the situation with 401k's: Suppose instead of an IRA, you have a 401k plan with $500,000 of which $50,000 is after-tax funds same as above. Prior to 2009 it was common for the administrator of the 401k plan to issue two checks; one representing the after-tax funds and one representing the pre-tax funds. Then you would (assuming you were eligible at the time) convert the after-tax funds directly to your Roth IRA by simply depositing the after-tax check into the Roth account while depositing the pre-tax check in your pre-tax IRA. This strategy seemed to be a loop hole to the pro-rata rule above because IRA and employer plan rules while they seem similar do have notable differences.
Then in 2009, IRS issued some guidance on this common strategy (which I won't go into the details here) that basically indicated that the above loophole was not allowed, at least if you wanted to do this you had to go to great lengths to do it right (again I'll skip the details for now) which were essentially not practical thus the common strategy of getting the two checks to convert the after-tax funds directly to a Roth was not allowed. There remained some debate on the subject but most practitioners preferred to go the conservative route with clients and advise that this strategy was no longer allowed however many plans continued to offer the separate checks unaware of the IRS notice that went out in 2009.
Well 5 years later we finally have a definitive answer to this question from IRS notice 2014-54 which is an emphatic YES! This is really great news and makes things quite simpler for those who have after-tax funds in their 401k. It also opens up some planning opportunities that were not previously allowed which I will provide more detail on in the coming weeks after I myself learn more about this new ruling. Expect to hear more about this, and other topics after I attend the Ed Slott Master Elite IRA Advisor Group workshop in the first week of November.
If you have any questions on whether this may apply to you please feel free to contact me directly.