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IRS Expands the Rules on Rolling Over After-Tax QP Funds to a Roth IRA and Other Plans

Posted by James M. Carlson
Sep 26 2014

On Thursday, September 18, 2014, the IRS adopted a new tax position for those individuals who have after-tax (basis or non-taxable funds) within an employer sponsored retirement plan. Under existing IRS rules, many individuals are unable to contribute only the after-tax amounts into a Roth IRA unless the individual uses the complicated approach discussed in the July, 2013, Pension Digest.

This change is very favorable to taxpayers and will be well received by taxpayers and their tax advisors. Taxpayers have been waiting for many years for the IRS to issue additional guidance on the topic of converting after-tax funds. Tax certainty for taxpayers has improved. With some limits, the IRS will apply the new rules retroactively.

The IRS issued Notice 2014-54 setting forth its new position on how a taxpayer is to allocate after-tax amounts (i.e. basis) when he or she receives a distribution from a 401(k) plan or other plan containing both taxable and nontaxable amounts and a portion of the distribution is to be directly rolled over to a traditional IRA and another portion is to directly rolled over to one or more other plans such as a 401(k) or a Roth IRA. As described, the IRS’ new position modifies the pro-rata taxation rule in a radical manner. It does not eliminate the pro-rata rule. The new rules will apply to distributions made on or after January 1, 2015. The IRS has also issued guidance as to what rules apply to distributions occurring before January 1, 2015. The IRS has stated it will modify the safe harbor rollover explanations for pension plan distributions it has previously furnished. An explanation of the new allocation rules will be set forth in the revised safe harbors.

In Notice 2009-68 the IRS had furnished guidance confirming that a pro-rata taxation rule must be applied when a person with both pre-tax and after-tax funds within a QP takes a distribution from a plan containing both types of funds. For example, a person who had $100,000 in her 401(k) comprised of $80,000 being taxable and $20,000 be nontaxable was NOT allowed to directly rollover only the $20,000 of nontaxable portion into her Roth IRA.

As result of this notice, the person described above will be able to directly rollover the $20,000 of non-taxable funds into her Roth IRA and the remaining taxable funds of $80,000 into her traditional IRA.

An individual will no longer be required to follow the complicated procedures as discussed in the July, 2013, Pension Digest in order to be contribute the $20,000 of after-tax dollars into her Roth IRA.

What are the new allocation rules?

Rule #1. A person will be treated as receiving a single distribution even if the funds are sent to multiple destinations such as a portion to a traditional IRA, a portion to a Roth IRA, or a portion to another 401(k) plan. This true even if multiple distributions from the same plan are considered made as of the same time. This is true even if there are actual differences due to administrative timing issues.

Rule #2. If the pre-tax amount is less than the amount which is directly rolled over to one or more eligible plans, then the entire pre-tax amount is assigned to the distribution amount which was directly rolled over and the participant may select how the pre-tax amount is allocated among the multiple plans. The participant must inform the plan administrator of the allocation prior to the time of the direct rollover(s).

Rule #3. If the pre-tax amount equals or exceeds the distribution amount directly rolled over to one or more eligible plans, the pre-tax amount is assigned to the portion which was directly rolled over up the amount of the direct rollovers. Each direct rollover would consist solely of pretax amounts. If there are any remaining pre-tax amounts, such amounts will be assigned to any standard rollover up to the amount of such standard rollovers. If there is a pre-tax amount remaining after all direct rollovers and standard rollovers, then any remaining pre-tax amount is to be included in the person’s income. A standard rollover is when the distribution has been made to the person who then complies with the standard rollover rules. If the remaining pre-tax amount is less than the amount rolled over in the standard rollovers, then the individual can select how to allocate the pre-tax amount among such plans. If the amount rolled over to an eligible retirement plan exceeds the portion of the pre-tax amount assigned to the plans, the excess must be an after-tax amount.

In order to discuss these new rules the IRS furnished the following examples as modified by CWF. Employee A participant in a 401(k) and she has balance of $250,000 of which $200,000 is pre-tax and $50,000 is after tax. The plan covering Employee A does not authorize any Designated Roth contributions.

Example #1. Employee A instructs the plan administrator that she wishes to withdraw $100,000 with $70,000 being directly rolled over to a traditional IRA and the remaining $30,000 paid to her. Under the new rules, the $70,000 directly rolled over to her traditional IRA arises solely from her pretax funds. This is so because the pre-tax amount ($80,000) exceeds the amount directly rolled over ($70,000) . The other $30,000 is paid to Employee A. $10,000 of this $30,000 is taxable and the other $20,000 is non-taxable. Employee A does have the right to rollover such distribution (or a portion) as long as the 60 day rule is met. If Employee A only rolled over $10,000, it would be comprised of the remaining pretax funds.

If Employee A chooses to roll over $12,000, $10,000 would be pre-tax and $2,000 would be after- tax. If Employee A chooses to roll over the distribution(s) which were not directly rolled over, then the participant will need to decide how the pre-tax amount is allocated if there are multiple destinations. The participant must inform the plan administrator of the allocation prior to the time of the direct rollover (s).

Example #2. The same facts apply as Example #I, except Employee A directly rollovers $82,000 and she is paid $18,000. She directly rolls over $50,000 to her new employer’s qualified plan and she directly rolls over $32,000 to her traditional IRA. She has directly rolled over more than her pre-tax amount being withdrawn of $80,000.The new qualified plan does separately account for after-tax amounts. Since the direct rollover amount of $82,000 exceeds the pre-tax amount of $80,000 she has directly rolled over $2,000 of after-tax dollars.

She will have the right to allocate the pre-tax amount of $80,000 between the new qualified plan and the IRA. Conversely, she has the right to allocate the aftertax amount of $2,000 between the new qualified plan and the IRA She must do this prior to the time the direct rollover are made.

Example #3. The same facts apply as Example #2, except the new qualified plan does not account for after-tax contributions. This means the $2,000 of aftertax contributions must be allocated to the traditional IRA. Thus, the $50,000 directly rolled over to the qualified plan must all be pre-tax. The $32,000 directly rolled over to the IRA would be comprised of $2,000 of after-tax and $30,000 of pretax funds.

Example #4. The facts are the same as in Example #I, except the individual directly rolls over the entire $100,000 by sending $80,000 to a traditional IRA and $20,000 to a Roth IRA. She is able to allocate the pretax amount of $80,000 to the traditional IRA and the after-tax amount of $20,000 to the Roth IRA. Effective date of new rules and IRS reporting duties. The new rules will apply to distributions occurring on or after January 1, 2015.

The IRS also discusses what rules will be applied for distributions occurring before January 1, 2015. For distributions occurring between September 18, 2004, and December 31, 2014, taxpayers may apply a reasonable interpretation of the “old” rule or the “new” rule. Without a doubt, individuals with after-tax funds within an employer plan have been extremely hesitant to move such funds into a Roth IRA or a designated Roth IRA account as the law has been murky. The IRShas removed much of the uncertainty.

For distributions occurring before September 18, 2004, taxpayers may generally apply the same reasonableness standard as now applies to the remainder of 2014. However, this standard does not apply to any distribution from a designated Roth Account. In such case, the allocation of the pretax amounts must conform to the rules set forth in 402A regulation in effect on the date of the distribution.

These new rules may or may not require the IRS to rewrite its instructions for completing the Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc.) .

The IRS will be furnishing additional guidance. When a participant withdraws funds from an employer plan and such distribution includes a distribution of after-tax funds, box 5 must be completed to report such amount. It may be that each distribution may be reported on a separate Form 1099-R even though under the new rules multiple disbursements to different destinations are treated as a single distribution.

What About Designated Roth Funds?

Such funds arising from the individual’s elective deferrals are after-tax funds and are not taxable when withdrawn by the participant. The distribution of the related earnings, however, will be taxable unless the distribution is a qualified distribution. The Roth regulation provides that such funds are treated as a separate contract from other accounts within the employer plan when applying the taxation rules. In plan English this means, the designated Roth funds are not aggregated with other funds within the employer plan, including the earnings on such designated Roth funds.

A qualified distribution of the earnings related to the designated Roth funds is tax free (i.e. not includible in gross income). Currently, the Roth IRA regulations provide in part that “any amount paid in a direct rollover is treated as a separate distribution form any amount paid directly to the individual.”

Such regulation will be amended to adopt the new rule.

The IRS’ release of Notice 2014-54 was unexpected. Taxpayers and their advisors will start to use these new rules immediately. Others will wait until January 1, 2015. Such rules will certainly make it easier for an individual to move after-tax funds into a Roth IRA or a designated Roth account where that fantastic goal of tax free income may be realized.

CWF is proud of the fact that we had asked/suggested to the IRS in prior years to furnish additional guidance on some of these issues. CWF will be suggesting to the IRS that it change its section 402(f) rules and direct rollover rules to require that the plan administrator furnish both the individual and the traditional or Roth IRA custodian (or plan administrator) a copy of the completed form whereon the individual sets forth his or her instructions regarding the allocation of the after-tax and pretax amounts.

Without question these direct rollover plan transactions are becoming more complicated, and the IRS should adopt procedural changes so that all parties will be better informed

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