On September 18, 2014, the IRS released guidance on the allocation of taxable and non-taxable amounts among rollover distributions to multiple destinations. The guidance applies to distributions from qualified plans, 403(b) plans, and governmental 457(b) plans.
Background
Amounts contributed to a retirement plan that have not yet been taxed, namely pretax elective deferrals, employer contributions, and earnings on plan accounts, are generally taxed in the year of distribution. Amounts that have been taxed — traditional after-tax employee contributions and Roth deferrals — are not taxed when distributed. If a participant’s account includes both pretax and after-tax amounts, then a distribution from the account is treated as including a pro rata share of each. Designated Roth Accounts must be tracked separately from other plan balances.
The taxability of a distribution may be deferred if the payment is rolled over to an eligible retirement plan. A rollover is generally limited to the portion of the distribution that is otherwise includible in gross income but an exception applies if a non-taxable portion is transferred in a direct rollover to a qualified plan that provides for separate accounting for the non-taxable portion or to an IRA.
Prior guidance provided that if a distribution included after-tax contributions and only a portion of the distribution was directly rolled over, the amount rolled over and the amount paid to the participant would each include a pro rata share of pre- and post-tax amounts. The IRS reached this result by concluding that amounts directly rolled over to more than one destination should be treated as separate distributions.
The new IRS guidance states that for purposes of determining the proration of a distribution that consists of after-tax (including Roth) and pretax amounts, multiple distributions made at the same time (or within a reasonable timeframe due to administrative delays), whether or not to multiple destinations, are treated as a single distribution. The guidance provides several examples to demonstrate how the allocation of pre- and post-tax amounts is handled.
The new guidance permits a participant more flexibility in structuring rollover distributions. A participant can effectively roll all the non-Roth, after-tax money to a Roth IRA, but only if all pretax dollars are rolled over to an eligible retirement plan. The treatment of distributions from Roth accounts will mirror the rules for non-Roth distributions.
Planning Opportunity
After-tax non-Roth contributions have rarely been used since they became subject to the same non-discrimination test as matching contributions as part of the 1986 Tax Reform Act. The new IRS guidance provides a new planning opportunity in limited cases.
The planning involves using employee contributions to bring a participant up to his or her individual account limit (called the 415 limit) where they would not otherwise be able to reach that limit because of the deduction and deferral limitations. The following example described in a recent article by Sungard Relius illustrates the technique:
Jack ( age 37) is the sole employee and shareholder of Jack, Inc. Jack’s W-2 compensation for 2015 is only $60,000, yet Jack wants to contribute a full $53,000 (the 2015 415 limit) to his retirement plan. He knows he can make an elective deferral of $18,000 and make a $15,000 deductible profit sharing contribution, but that is only $33,000. So he contributes an additional $20,000 as an employee contribution.
Once Jack has contributed the $20,000, he has several choices:
He can leave it in the plan’s employee contribution account, but that means he will ultimately pay taxes on the earnings.
He can do an in-plan Roth rollover of the funds. Since the entire amount is already after-tax, there is no tax on the conversion. The potential 5-year recapture of the premature distribution penalty tax does not apply. Of course, if Jack already has employee contributions and earnings in his employee contribution account, or he waits to roll over the funds long enough for earnings to accumulate, the earnings will be taxable on conversion and potentially subject to the recapture penalty.
He can roll the funds to a traditional IRA, with similar consequences as the first alternative.
He can roll the funds to a Roth IRA, with similar consequences as the second alternative.
This technique works best where Jack has no other employees so there is no non-discrimination testing involved. The employee contributions are not subject to the 25% deduction limit or the penalty for nondeductible contributions.
Before undertaking any rollover, a participant should thoroughly discuss the matter with his or her tax and financial advisor as there are nuances to this planning that are not discussed here.
Most plans will not need an amendment to deal with the changed tax treatment. However, if a plan does not permit after-tax employee contributions and the employer wishes to allow them, the employer must amend the plan to do so. Note that if the plan is a safe harbor 401(k) plan, the amendment must be effective for the following plan year and must be adopted before the start of that year (except that for 2014, a safe harbor plan may adopt an in-plan Roth rollover feature during the year to be effective on the date of adoption).
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