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
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
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