In Notice 2014-54, the IRS provides new guidance on the allocation of pretax and after-tax amounts from qualified plan rollovers. Specifically, when qualified retirement plan participants make distributions to multiple accounts from plans containing both pretax and after-tax dollars, the amounts are now (as of January 1, 2015) treated as a single distribution. Therefore, participants can allocate a pretax and after-tax basis to separate accounts.
So, what does the single distribution rule on qualified plan rollovers mean for your clients? Here, I'll summarize what you and your clients need to know, including possible tax advantages and some planning pitfalls.
"Cream in the Coffee"
When after-tax contributions are made to a tax-deferred qualified plan, distributions from that plan naturally include both pretax and after-tax dollars (a blend of cream and coffee). Under the previous rule, each account receiving a qualified retirement plan distribution would be considered separately and include a pro rata portion of both the pretax and after-tax amounts. The plan participant could not, say, choose to roll the pretax amount to a traditional IRA and the after-tax amount to a Roth IRA.
- Your client's 401(k) rollover distribution consists of 70 percent pretax and 30 percent after-tax money.
- She distributes 70 percent of the total assets to a traditional IRA and 30 percent to a Roth IRA.
- Under the old rule, these would be treated as separate distributions—each one split 70/30 between pretax and after-tax dollars, making 70 percent of the amount disbursed to the Roth IRA taxable.
For years, advisors have wanted to separate the cream from the coffee. That way, pretax money could be rolled over to a traditional IRA and after-tax money rolled over to a Roth IRA as a tax-free conversion. Well, now you can do just that.
What's New (and What's Not)?
Notice 2014-54 provides the guidance you may need to help your clients avoid paying up-front taxes on rollovers containing both pretax and after-tax amounts:
- Under the single distribution rule on qualified plan rollovers, pretax dollars can be allocated to one place and after-tax dollars to another because the IRS will treat the amounts as a single distribution rather than as separate distributions.
- The rules dictating what portion of the client's distribution is pretax and what portion is after-tax have not changed.
The Best Strategy
In theory, pretax and after-tax distributions from a qualified plan can be allocated to any type of retirement account. The most beneficial strategy, however, is to allocate pretax money to an IRA rollover and, at the same time, allocate the after-tax portion to a Roth IRA:
- This prevents your clients from having to pay up-front taxes proportionately on the rollover.
- It maintains the status of pretax money in a tax-deferred account while converting the after-tax portion of the rollover tax-free.
- Your client is a 401(k) plan participant who has $350,000 in his 401(k) when he leaves his job.
- His 401(k) plan has $300,000 of pretax money (salary deferrals and cumulative earnings) and $50,000 of after-tax contributions.
- Your client decides to roll out of his employer-sponsored plan.
- He tells the plan administrator how he wants the funds allocated, with the pretax funds ($300,000) rolled to an IRA and the after-tax funds ($50,000) converted tax-free to a Roth IRA.
- The $50,000 in the Roth IRA can now grow tax-free.
If your client had distributed the entire $350,000 as a direct rollover to his IRA tax-free, he would have maintained the tax deferral on the entire amount. But future earnings on the entire amount would have been taxable, and future distributions from his IRA would have been based on the pro rata rule.
Individuals cannot take a distribution of only the after-tax money and leave the pretax money in the qualified plan. The same participant above could not distribute just $50,000 and allocate it to after-tax funds. Such a distribution would include both pretax and after-tax funds proportionately. To roll over all of the after-tax contributions to a Roth IRA, the participant would need to do the following:
- Disburse the full amount of the qualified plan (all pretax and after-tax amounts)
- Roll over all the pretax money to a traditional IRA or eligible retirement plan
- Roll over all the after-tax money to a Roth IRA
To benefit from this rule, individuals and their employer-sponsored plans must meet the following requirements.
- The single distribution rule is for qualified plans only, not IRAs.
- It does not apply to Roth 401(k)s.
- The participant's qualified plan must allow for after-tax contributions.
- The participant must have made after-tax contributions to his or her qualified plan.
- The participant must be able to take a distribution from his or her qualified plan that is eligible for a rollover.
- Plan disbursements must be scheduled at the same time. If they're done at different times, the participant cannot benefit from the new rule.
- The participant must inform the plan administrator of the pretax and after-tax allocation prior to the direct rollover.
If your clients meet these requirements, the ability to allocate pretax and after-tax amounts in rollovers from qualified plans can provide tax planning advantages. But, of course, there are some downsides.
1) Tax on early distributions. An employee who chooses to roll over a qualified plan to an IRA will lose the penalty-free early distribution option that is available to 401(k) plan participants who separate from service between ages 55 and 59½ (Publication 560, "Tax on Early Distributions").
2) Required minimum distributions (RMDs). The IRS requires individuals to begin taking RMDs the year in which they turn 70½. For 401(k), profit-sharing, 403(b), or other defined contribution plans, however, individuals can defer RMDs until April 1 following the later of the calendar year in which they reach age 70½ or the calendar year in which they retire, as long as the plan terms allow for it and they are not a 5-percent owner. Those who roll over the pretax and after-tax amounts in their plan to an IRA will be subject to RMD rules at age 70½, regardless of whether they are still working.
Considering all of this, the most important takeaway is the ability for clients with both pretax and after-tax money in their qualified plans to allocate the two portions of distributions to different retirement accounts.
- To be treated as a single distribution, plan distributions must be scheduled to be made at the same time, regardless of whether the disbursement is sent to a single destination or multiple destinations.
- The new rule does not affect the way pretax and after-tax money is distributed from a plan.
- Partial distributions still consist of both pretax and after-tax funds proportionately.
Although this new rule presents more flexible retirement planning solutions, it will likely benefit higher-earning individuals who have sufficient income to make after-tax contributions over and above the pretax plan limit.
It's All About Planning
This new rule can be tricky. Be sure to contact the plan administrator and inform him or her of the pretax and after-tax allocation before requesting a direct rollover. Your pro rata calculations may be dependent on whether the plan administrator uses separate or sub-account accounting methods for elective deferrals and after-tax contributions and earnings. In short, if you have clients interested in this option, be sure to plan carefully (as always) and consider any potential pitfalls before moving forward.
Has the single distribution rule on qualified plan rollovers affected your clients' retirement planning? Have you been able to use this rule to their advantage? Please share your thoughts with us below.