Finally Some Good News: Guidance on Splitting Pre-Tax and After-Tax Rollovers
As advisors, we frequently encounter circumstances where a client wants to rollover a qualified retirement plan into an IRA. And there are a number of distinct advantages to doing so. For example, rolling funds into an IRA should allow an investor to continue tax-deferred growth while gaining more control and flexibility over their retirement savings. But, until recently, the rollover process for some more complicated accounts could be tricky. Fortunately, new guidance from the IRS is making it easier for investors to split their pre-tax and after-tax contributions.
But before going into greater detail about how this new guidance impacts the rollover process, we should provide a little background. There are two types of rollovers: direct rollovers and indirect rollovers. Direct rollovers occur when assets transfer from an employer-sponsored retirement plan directly into a rollover IRA. An indirect rollover is when the employer-sponsored plan issues a check payable to the former participant, and they distribute the money to an IRA within 60 days from receiving the check. The direct rollover is probably the most efficient way to avoid any mandatory state or federal withholding taxes, as well as a possible 10 percent penalty, because it removes the risk that the check will be lost or forgotten about during the 60-day rollover period. However, in the case of splitting rollovers that have both pre-tax and after-tax dollars involved, it’s not quite so simple.
Most people who contribute to a traditional, employer-sponsored 401(k) plan receive a tax deduction for their contributions. Some plans allow participants to make additional after-tax contributions over the deductible thresholds, up to the annual defined contribution plan limit. As a result, some 401(k) plans will contain pre-tax contributions together with after-tax contributions, and the earnings on both of them. This can be a source of much confusion, because the rules surrounding the rollover of these assets were unclear and left up to interpretation.
Interpreting IRS Notice 2009-68
So, how best to approach rollover situations with both pre- and after-tax contributions? Generally speaking, the goal is to roll just the pre-tax and earnings portions of the 401(k) into a contributory IRA and to roll the after-tax portion into a Roth IRA. However, Notice 2009-68 provided the IRS’ sole guidance on this matter. The notice stipulated that the only way to successfully split the pre- and after-tax dollars was to have an employee take an outright distribution of the entire plan balance, then roll over the pre-tax portion of the distribution via the previously mentioned “60-day rollover.”
This occurred because the notice states that the portion of a 401(k) rolled over to an IRA, after outright distributions, must come from pre-tax money first. While it may seem straightforward, the rule actually created some substantial problems.
An example may be helpful. Assume you have a $1 million 401(k) plan. You want to rollover $200,000 in after-tax dollars to a Roth IRA, and the rest to an IRA. But under Notice 2009-68, 20 percent of both the Roth IRA and the IRA are now counted as comprising after-tax dollars because of the pro-rata treatment required by the rule. Obviously, this is not the notice’s intent, and actually results in some reportable income from the Roth conversion as it’s funded with a portion of pre-tax dollars.
In spite of this, too often in practice plan administrators and custodians alike did not follow the notice’s guidance. They would still issue two separate checks to participants, and tell them to invest the pre-tax amounts directly to the IRA and the after-tax amounts as they wished (either in an outright distribution or into a Roth). This result made many advisors and CPAs uncomfortable because it was not expressly permitted and, in fact, seemed to be implicitly prohibited under the notice.
Advisors looking for another way around the problem often suggested that participants take an outright distribution of the entire 401(k). Once the funds are deposited in a client’s account, they have 60 days to roll the pre-tax dollars into an IRA and the after-tax dollars into a Roth IRA. This avoided the tax trap, but had its own issues. First, the transaction was complex and there was a chance the client could miss the 60-day window. Second, due to the lack of IRS guidance, it was not entirely clear that this approach was sanctioned.
Interpreting IRS Notice 2014-54
Recently, the IRS issued Notice 2014-54, which offers new guidance on distributions of pre- and post-tax distributions from qualified plans. Under the new rules, the IRS states explicitly that in a situation where a direct rollover is going to two or more accounts and originates from a single disbursement from a plan, the “recipient can select how the pretax amount is allocated among these accounts. To make this selection, the recipient must inform the plan administrator prior to the time of the direct rollovers.”
As a result, it is no longer necessary for the plan administrator to send the participant one check, in the form of an outright distribution. Now, they can send two checks, one for the pre-tax portion and the other for the after-tax portion. In addition, they can send the checks directly to the IRA and Roth IRA, respectively, as long as the participant notifies the plan administrator so that the distributions can be reported properly on tax form 1099. In addition, if the participant does NOT roll the after-tax portion into a Roth but takes it outright instead, the notice reaffirms the existing treatment of that distribution. The rollover is assumed to be all pre-tax (to the extent of the rollover) and the amount kept outright is assumed to be all after-tax (plus any remaining pre-tax portion that wasn’t already part of the rollover). Finally, the new rules also apply to 403(b) and 457 plans, in addition to 401(k) plans.
Using the same example as earlier, assume you have a $1 million 401(k) plan with $800,000 in pre-tax dollars and $200,000 in post-tax dollars. The new rules allow for the plan administrator to issue a check for $200,000 and also a corresponding check for $800,000. The $200,000 can be used as a Roth IRA tax-free conversion and the remaining amount can be used for a traditional IRA tax-free rollover.
What these notices mean for you
The IRS’ new notice allows advisors and clients both to move funds more efficiently, making life much simpler for all parties. The new rules do still require that the account owner remove all 401(k) funds from the plan in order to fund a Roth conversion with the entire balance of the after-tax portion. Also, the plan administrator may still issue two 1099-R tax forms, one for each distribution. This will not affect the tax treatment as a single disbursement for allocation purposes. One of the most important steps in the rollover process is to make sure that the proper pre- and post-tax allocation is reported correctly to the plan administrator so that they can accurately inform the IRS.
These new rules can be convoluted, and advisors may need to help guide clients through them. But in the end, clarification of the rules surrounding the rollover of pre- and post-tax dollars into separate accounts has positive implications for qualified retirement plan holders.
Mike Torney and Jenny Baraba contributed to this article.
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