IRA

Moving After-Tax Retirement Plan Distributions to a Roth IRA Has Become Easier

November 13, 2014
By: Chin Kim

Learn how your clients who have after-tax dollars within their employers' retirement plans directly roll the after-tax dollars to a Roth IRA.

With the recently released IRS Notice 2014-54, we now have guidance on how retirement plan participants who have after-tax dollars within their employers' retirement plans can directly roll the after-tax dollars to a Roth IRA. In doing so, the participant is essentially electing a tax-free Roth IRA conversion.

Before the Notice, guidance regarding moving retirement plan (i.e., 401(a), 401(k), 403(b), and governmental 457(b)) disbursement of pretax and after-tax dollars to multiple types of accounts was unclear and debated by experts. Now, participants with after-tax dollars (other than designated Roth accounts) in their retirement plans are able to move eligible rollover distributions directly to Roth IRAs simply by providing instructions to the plan administrator prior to the time of the disbursement.

Distributions for participants with pretax and after-tax dollars in their accounts come out of the plan on a proportionate basis. This has often been referred to as the "cream in the coffee" rule. And, prior to the Notice, it was suggested by some experts that this ratio followed the distribution to its new destination. 

For example, if an individual was rolling money out of his/her employer plan after separating from service and preferred to move the pretax dollars into an IRA and the after-tax dollars into a Roth IRA, he/she was not able to pick and choose, but rather constrained by the "cream in the coffee" rule. That is, if a distribution was half pretax and half after-tax dollars, and some of it was moved to a traditional IRA and the rest was moved to a Roth IRA, the rollover into each of these accounts would consist of half pretax and half after-tax dollars. As a result, the taxpayer would have after-tax dollars in the traditional IRA and taxes due on the pretax dollars that converted into the Roth IRA.

Other experts suggested different processing strategies to move the funds to the desired destination without the proportionate allocation of the pretax and after-tax dollars. In any case, none of these strategies was supported by clear IRS guidance.

Now, as a result of Notice 2014-54, participants can direct the way their after-tax dollars are allocated.

Here's an example of the impact of the Notice. Assume the following:

  • A $120,000 investment is composed of 50% pretax funds and 50% after-tax funds.
  • The retiring participant requests that $60,000 be directly rolled to a traditional IRA first and the remaining $60,000 be rolled to a Roth IRA.

 

Prior to Notice 2014-54 Following Notice 2014-54

Traditional IRA ($60,000) Composition:

  • Pretax = $30,000
  • After-tax = $30,000

Roth IRA ($60,000) Composition:

  • Pretax = $30,000
  • After-tax = $30,000

Result:

  • $30,000 is taxable as a Roth IRA
    conversion.
  • Taxpayer is responsible for tracking the pretax and after-tax dollars in the traditional IRA with all distributions to be taxed on a proportionate basis.

Traditional IRA ($60,000) Composition:

  • Pretax = $60,000
  • After-tax = $0

Roth IRA ($60,000) Composition:

  • Pretax = $0
  • After-tax = $60,000

Result:

  • Taxpayer moves the after-tax dollars to a Roth IRA and was able to establish a Roth IRA without incurring tax liability.
  • Because only the pretax dollars are moved to the traditional IRA, there will not be any separate tracking of after-tax dollars relating to this transaction.


This new allocation rule in Notice 2014-54 will apply to all distributions made on or after January 1, 2015. However, under the transition rules, taxpayers may apply a "reasonable interpretation" for prior distributions. Please check with the employer plan's administrator for specific details.  

Tax-free Roth IRA distributions can be especially desirable when helping your clients plan a retirement income strategy. The clarification provided in the Notice gives you an opportunity to provide value by helping your client easily position retirement dollars into a Roth IRA.

For answers to questions regarding the Notice, contact the Retirement Strategies Group at (800) 722-2333, ext. 3939. We'll be glad to help you.


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Chin is currently an Assistant Vice President of Regulatory Compliance in the Retirement Solutions Division at Pacific Life. Previously, he led the Retirement Strategies Group, as Assistant Vice President in the Retirement Solutions Division at Pacific Life. His core responsibilities included sharing and supporting retirement strategies concepts through development of marketing materials and tools and leading the team members in the field and in the home office.

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