Some participants in 401(k) plans made nondeductible after-tax contributions to their accounts. Upon retirement, they wanted to segregate the after-tax portion of their benefits from the pre-tax portion, so they could roll the pre-tax portion into a traditional individual retirement account and the after-tax portion into a Roth IRA.
In Notice 2009-68, the Internal Revenue Service said that if all of the funds are rolled over, the basis would be allocated pro rata, so that a portion of the amount rolled into the Roth IRA would be a taxable conversion.
Taxpayers discovered a workaround. They would take a lump-sum distribution and deposit it into a taxable account. Then they would roll the pre-tax amount to a traditional IRA, leaving the after-tax portion behind. Finally, they would roll the after-tax amount into a Roth IRA. All of this had to be completed within 60 days of receipt of the distribution.
In Notice 2014-64, the IRS reconsidered its position and allowed participants to select how the pre-tax amount is to be allocated among multiple destinations.
On Oct. 6, 2014, the IRS issued proposed regulations extending this concept to distributions from designated Roth accounts.
Previously, if a participant rolled over a portion of a distribution from a designated Roth account to a Roth IRA, it would include only a pro-rata portion of the earnings. The participant would be taxable on the remaining portion of the earnings if it wasn’t a qualified distribution. To be a qualified distribution, it must be made at least five years after the year of the first designated Roth contribution and after the participant turns age 59 ½ or has a disability.
The IRS issued the regulations in final form effective May 18, 2016 (T.D. 9769). Under the final regulations, a participant may allocate the earnings to the portion rolled over into another designated Roth account or Roth IRA, thus minimizing the amount that would be taxable if the portion not rolled over isn’t a qualified distribution. The participant may also allocate the earnings in the case of rollovers to multiple destinations, such as another designated Roth account and a Roth IRA.