IRS Guidance Relaxes Allocation Rules Making After-Tax Rollovers Easier
Pursuant to proposed regulations and related guidance the IRS released on September 18, 2014, the IRS will allow eligible rollover distributions of pre-tax and after-tax amounts from a qualified retirement plan, a 403(b) plan, or a governmental 457(b) plan to be split and allocated to different destinations on a tax-favored basis. Specifically, the proposed regulations
remove the rollover allocation rule for distributions of after-tax amounts made from designated Roth accounts, and Notice 2014-54 p
rovides guidance on how to allocate distributions of pre-tax and after-tax amounts that are made to multiple destinations. These new rules give plan participants more flexibility to maximize their after-tax savings and provides plan sponsors with more certainty concerning how after-tax amounts distributed from retirement plans may be treated.
Background – Notice 2009-68 (Safe Harbor Notice)
Under the Safe Harbor Notice, if a participant's account balance in a qualified plan, a 403(b) plan, or a governmental 457(b) plan includes both pre-tax and after-tax amounts, then each destination for an eligible rollover distribution from the account must include a pro-rata share of both pre-tax and after-tax amounts. This result was not consistent with the approach many plans took with respect to the allocation of after-tax amounts. In practice, many plan sponsors attempted to work around this unwanted result to avoid the tax implications, but the methods for doing so were complex and not explicitly approved by the IRS – until now.
Guidance – New Rules Under Notice 2014-54
Under the new rules set forth in Notice 2014-54 and the proposed regulations, all eligible rollover distributions from a qualified retirement plan, a 403(b) plan, or a governmental 457(b) plan that are made to a recipient at the same time will be treated as a single distribution, regardless of whether the recipient has directed the payments be made to a single destination or multiple destinations. In addition, if the pre-tax amount of the 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 allocated to the direct rollover. In situations where payments are directly rolled over to two or more eligible retirement plans, the participant can select how the pre-tax amount is allocated among the plans, as long as he or she notifies the plan administrator of the allocation before the payments are directly rolled over.
If the pre-tax amount equals or exceeds the amount of the distribution that is directly rolled over to one or more eligible retirement plans, the pre-tax amount is assigned first to the portion of the distribution that is directly rolled over up to the amount of the direct rollover, then to any 60-day rollovers up to the amount of the 60-day rollovers. If the remaining pre-tax amount is less than the amount rolled over in 60-day rollovers, the recipient can select how the pre-tax amount is allocated among the plans that receive 60-day rollovers. Any remaining pre-tax amount is includible in the participant's gross income for the tax year of the distribution. If the amount rolled over to an eligible retirement plan exceeds the pre-tax amount allocated to the plan, the excess is an after-tax amount in the eligible retirement plan.
Applying the new guidance to an example: if the participant's eligible rollover distribution of $100,000 consisted of $80,000 in pre-tax contributions and $20,000 in after-tax contributions, the participant could direct that $80,000 (pre-tax)
be rolled over to a traditional IRA and $20,000 (post-tax)
to a Roth IRA. The amount directly rolled over to the traditional IRA would consist entirely of pre-tax amounts and the amount rolled over to the Roth IRA would consist entirely of after-tax amounts.
Other Key Points to Consider
The new guidance applies only to eligible rollover distributions and does not change the requirement for allocation of the investment in the contract between a lump sum and an annuity when a participant is receiving both. For example, if a participant has a DROP account that is paid in a lump sum but will also receive a monthly pension benefit, the plan sponsor must first allocate tax basis between the lump sum payment and the annuity, pursuant to Internal Revenue Code Section 72(d). The tax-free portion assigned to the lump sum payment could then be distributed pursuant to the new guidance – whereby a pro rata allocation of the after-tax amount (attributed to the eligible rollover distribution amount) would not be required when the member elects more than one destination for the lump sum.
While the new rules provide that multiple disbursements to different destinations are treated as a single distribution, each disbursement may still be required to be reported on a separate Form 1099-R.
The Notice indicates that the IRS will be revising the 402(f) safe harbor explanations in its 2009 model rollover notice to reflect the new guidance and the revised method for allocating after-tax amounts. Plan sponsors should consider reviewing and updating their 402(f) safe harbor notices accordingly.
The Notice and proposed regulations indicate the new allocation rules officially apply to distributions made on or after January 1, 2015. However, the IRS says the proposed rules may be applied to distributions made on or after September 18, 2014; in doing so, taxpayers may apply a "reasonable interpretation" of the rollover rules under the Notice to allocate pre-tax and after-tax amounts (attributed to the eligible rollover distribution amount) among disbursements made to multiple destinations.
If you have questions or need more information about the impact of the proposed regulations and Notice 2014-54 on your retirement plan, please contact Mary Beth Braitman
, Robert Gauss
, Lisa Erb Harrison
, Tiffany Sharpley
, Malaika Caldwell
or any member of Ice Miller's Employee Benefits Group