On Sept. 19, 2015, the Internal Revenue Service issued new guidance, which changes how distributions from qualified retirement plans to multiple destinations will be treated when it comes to allocating pre-tax and after-tax amounts.
When an employee’s qualified retirement account1 that holds both pre-tax and after-tax funds disburses funds to more than one destination, how are pre-tax and after-tax funds treated? IRS Notice 2014-54, effective Jan. 1, 2015 addresses that question.2 The employee may direct those allocations by election in certain cases. And, because Notice 2014-54 affects employer-sponsored designated Roth accounts, proposed regulations would provide a conforming rule.3
Pre-tax funds held in an account represent amounts that haven’t yet been taxed, but will be when distributed. Employer contributions, employee contributions of pre-tax compensation and investment earnings on all account funds are pre-tax funds. Pre-tax funds are said to have zero basis. Distributions of such funds are generally taxable, 4 unless rolled over to another qualified retirement account or individual retirement account.
After-tax funds held in an account represent dollars contributed to an employee’s retirement account that have been subjected to income taxes. To the extent a retirement account holds after-tax funds, the account is said to have “basis.” Distribution of funds having basis avoids income taxation.
When several disbursements are scheduled to be made at the same time (disregarding differences due to reasonable delays to facilitate plan administration), a single disbursement is deemed to have occurred for purposes of dealing with determining the total amount of pre-tax and after-tax funds distributed. This doesn’t mean that only a single Form 1099-R (for distributions from pensions, annuities, retirement or profit-sharing plans, IRAs insurance contracts, etc.) need be issued. But each Form 1099-R must reflect the pre-tax and after-tax allocations described in the Notice.
Notice 2014-54 provides various examples illustrating what portion of several disbursements treated as a single disbursement is treated as pretax versus after-tax amounts.
Mae participates in a qualified retirement account sponsored by her employer. Mae’s account holds assets worth $250,000. Mae contributed after-tax funds of $50,000. Therefore, Mae’s account has $200,000 in pre-tax funds, representing 80 percent of the account’s value, and $50,000 in after-tax funds (basis), representing 20 percent of the account’s value.
Mae leaves her job and begins work with a new employer. Mae plans to request a $100,000 distribution from her retirement account held under her old employer’s plan, specifying that a $70,000 direct transfer be made to her retirement account held under her new employer’s plan and a $30,000 payment be made to herself.
Under Notice 2014-54, both plan disbursements will constitute a single distribution for purposes of determining pre-tax and after-tax amounts allocated to each of the two distributions.
The $100,000 total of both distributions will include $80,000 of pre-tax funds (80 percent of $100,000) and $20,000 of after-tax funds (20 percent of $100,000). Example 1 of Notice 2014-54 illustrates that the $70,000 direct transfer to Mae’s new plan account will consist entirely of pre-tax funds because more than $70,000 of pre-tax funds will be distributed. The remaining $10,000 of distributed pre-tax funds will be assigned to the $30,000 distribution Mae receives. The other $20,000 of Mae’s $30,000 distribution will constitute after-tax funds. As a result, Mae will pay income taxes on $20,000 of her $100,000 distribution. The Notice’s convention of allocating pre-tax funds to the direct rollover tends to minimize the amount of Mae’s taxable income.
What if Mae instead requests a $50,000 direct rollover to her new plan account that separately accounts for after-tax contributions, plus a $32,000 direct transfer to an IRA? Example 2 of Notice 2014-54 observes that that the combined $82,000 amount exceeds Mae’s $80,000 of basis. Under the Notice, all of Mae’s basis is carried out of the plan to the receiving accounts. But the Notice permits Mae to select how the basis is allocated between the two destination accounts. Mae must make that selection before the direct rollovers are made by informing the distributing plan of her selection. Thus, planning is required before the distributions are requested. Mae can’t wait until after the transfers are made to decide how to allocate pre-tax amounts between the two accounts.
Examples 1 and 2 illustrate the Notice’s general rule that: :
If the pre-tax amount with respect to the aggregated disbursements that are treated as a single distribution is less than the amount of the distribution that is directly rolled over to one or more eligible retirement plans, the entire pre-tax amount is assigned to the amount of the distribution that is directly rolled over.
What if the receiving employer plan doesn’t account for basis? In that case, Example 3 of Notice 2014-54 provides that pre-tax amounts are assigned to the receiving plan first. All of Mae’s $50,000 direct rollover to her new plan account would be pre-tax amounts. All of Mae’s $2,000 of basis will reside in the transferee-IRA.
What if Mae sets up a Roth IRA, then directs the plan administrator to transfer $80,000 to a traditional IRA and $20,000 to a Roth IRA? Example 4 of Notice 2014-54 provides that Mae is permitted to allocate all $20,000 of her after-tax funds (basis) to the Roth IRA and all of her $80,000 of taxable funds to the traditional IRA. This ability to isolate basis to facilitate a Roth IRA conversion isn’t available to traditional IRAs that hold both after-tax and pre-tax funds. However, an IRA can be transferred into a qualified plan account. Because Notice 2014-54 applies to disbursements from a qualified plan account, it may be possible to follow Example 4 when it comes to IRA transfers into such an account.
Each of the Notice’s examples illustrates aggregate distributions that exceed the pre-tax amount of the distributing account.
When aggregate distributions are equal to or less than the pre-tax amount of the distributing account, the pre-tax amount is assigned first to direct rollovers, then to 60-day rollovers (that is, not direct transfers), then to taxable distributions. Furthermore, the plan participant can select how the pre-tax amount is allocated among the plans that receive 60-day rollovers.
Transitional rules provide great flexibility. For distributions before Jan. 1, 2015 but after Sept. 18, 2014, plan administrators may adopt any reasonable interpretation of IRC Section 402(c)(2), including, for example, either pro rata allocation of basis or application of the rules contained in Notice 2014-54. Designated Roth accounts may use the rule of Treasury Regulations Section 1.402A-1, Q&A-5(a), requiring treatment of each distribution as a separate distribution, with each such distribution receiving a pro rata allocation of basis. Further, the Notice provides that “it would be reasonable for a plan administrator to switch from allocating pretax amounts using the separate distribution allocation rule to allocating pretax amounts in the manner described in section III of this notice as timely selected by the recipient.”
Distributions made before Sept. 19, 2014 may use the same “reasonable interpretation” standards, except for designated Roth accounts. Those accounts must follow Treasury Regulations Section 1.402A-1, Q&A-5(a).
The Notice states that the IRS-provided safe harbor notice that must be given to recipients of plan distributions will be updated. Hopefully, inclusion of this important topic will encourage planning.
1. Meaning plans maintained under Internal Revenue Code Sections 401, 403(b) and 457(b), relating to plans maintained by a governmental employer described in Section 457(e)(1)(A).
2. Notice 2014-54; 2014-41 I.R.B. 1, Sept. 19, 2014.
3. Treasury Regulations Section 105739-11; 79 F.R. 56310-56312, Sept. 19, 2014.
4. See Internal Revenue Code Section 72.