Allocating Pretax and After-Tax Amounts to Multiple Destinations

For years, it wasn’t clear whether plan participants with after-tax money* in their accounts could roll over the after-tax portion of an eligible distribution to a Roth individual retirement account (IRA) and the pretax portion to another employer’s plan or a traditional IRA (or a combination).

In September 2014, the IRS provided the answer — and it was a thumbs up. Notice 2014-54 explains the rules for how to allocate pretax and after-tax amounts that are being distributed at the same time to multiple destinations.

Here’s an example: A participant wants one portion of a distribution to go to a new employer’s 401(k), another to go to a traditional IRA, and the balance to come to him. According to the guidance, all plan distributions that are scheduled to be made at the same time will be treated as a single distribution without regard to whether the distributed amounts are made to a single destination or multiple destinations. These rules apply to distributions from qualified plans, such as 401(k) plans, and to 403(b) and governmental 457 plans.

Background

IRS Internal Revenue Code (IRC) Section 72(e)(8) requires that partial distributions from participant accounts that contain both pretax and after-tax amounts include pro rata shares of both amounts. IRS Notice 2009-68 provided two model distribution notices with safe harbor explanations that plans can give to individuals who will be receiving eligible rollover distributions. The explanations state that when individuals have one portion of their account directly rolled over and another portion paid to themselves, each of the payments will include a pro rata portion of the after-tax contributions.

The new guidance incorporates IRC Section 402(c)(2), which says that when an amount transferred to a new employer plan or a traditional IRA contains pretax and after-tax amounts, the pretax amount will be distributed first. Thus, this guidance presents a middle-of-the-road approach that incorporates Sections 72(e)(8) and 402(c)(2) and provides new planning opportunities for participants with after-tax amounts who want to arrange a multiple destination distribution.

Applying the New Rules

The IRS notice contains four examples that clarify how payouts that include after-tax amounts and go to multiple destinations will work under the new rules.

The following facts apply in all four examples:

• The plan has no designated Roth provisions
• The participant has a total account balance of $250,000: $200,000 pretax + $50,000 after-tax
• $200,000 (pretax) ÷ $250,000 (account total) = 80% pretax
• Participant severs service and requests a distribution of $100,000
• Pro rata amounts = $80,000 pretax and $20,000 after-tax

In example one, the participant specifies a distribution of $70,000 by direct rollover to the qualified plan of a new employer:

• All $70,000 is pretax

The participant requests that $30,000 be paid to him:

• $10,000 is pretax, subject to the 20% income-tax withholding
• $20,000 is after-tax

Within 60 days, the participant rolls $12,000 into a traditional IRA:

• $10,000 is pretax
• $2,000 is after-tax

In example two, the participant specifies a distribution of $82,000 by direct rollovers:

• $50,000 to the qualified plan of the new employer
• $32,000 to a traditional IRA
• $80,000 of this amount is pretax and $2,000 is after-tax
• The participant is permitted to allocate the pretax amounts between the IRA and the qualified plan and is to inform the administrator of the choice

The participant requests $18,000 to be paid to himself:

• All $18,000 is after-tax

In example three, the participant specifies a distribution of $82,000 by direct rollovers:

• $50,000 to the qualified plan of the new employer
• $32,000 to a traditional IRA
• $80,000 of this amount is pretax and $2,000 is after-tax
• The new employer’s plan will not accept after-tax rollovers because it cannot account for after-tax amounts. Thus, the entire $50,000 rolled over to the new plan must be pretax
• $2,000 after-tax is all sent to a traditional IRA as part of the $32,000

The participant requests $18,000 to be paid to himself:

• All $18,000 is after-tax

In example four, the participant specifies a distribution of $100,000 by direct rollovers:

• $80,000 to a traditional IRA
• $20,000 to a Roth IRA
• The participant is permitted to allocate the entire pretax portion to the traditional IRA and the entire after-tax portion to the Roth IRA

Effective Date

The new rules generally apply to distributions made on or after January 1, 2015. However, taxpayers are permitted to apply the rules to distributions made on or after September 18, 2014.

* After-tax amounts discussed in this guidance are not designated Roth contributions