The IRS has recently cleared the pathway for high-income clients looking to maximize the value of their employer-sponsored retirement plan assets. The new rules change the way that after-tax retirement plan assets are treated upon distribution, providing flexibility and certainty for clients whose accounts contain both pre-tax and after-tax contributions. By allowing pre-tax and after-tax contributions to be distributed to the most appropriate retirement income planning vehicles with ease, the new IRS rules remove the complexities that previously discouraged clients seeking to maximize the value of these contributions, and eliminate the tax liability that accompanied a split distribution in the process.
Problems presented by the old rules
Prior to the release of IRS Notice 2014-54, if a client took a distribution from an employer-sponsored retirement account that contained both pre-tax and after-tax contributions, the regulations made it difficult to maximize the value of both the pre and after-tax values. The client had several unfavorable options.
The client had the option of rolling the entire distribution into another traditional account, where he would avoid current taxes on the pre-tax portion of the distribution, but in which the after-tax portion would continue to accumulate earnings that were merely tax-deferred. If the entire balance were rolled over into a Roth, the future distributions could be taken tax-free, but the client would owe current taxes on the pre-tax portion of the distribution.
Prior regulations permitted the distribution to be rolled partly into a traditional account and partly into a Roth, but the client was required to treat the distribution as two separate distributions, meaning that the distribution to each account would be treated as coming partly from pre-tax contributions and partly from after-tax contributions.
So, for example, if the client’s distribution of $100,000 consisted of $80,000 in pre-tax contributions and $20,000 in after-tax contributions, the client could direct that $80,000 be transferred to a traditional IRA and $20,000 to a Roth. However, the amount transferred to each account would be pro-rated (80-20 percent) so that 80 percent of the Roth transfer would be taxed.
Methods for avoiding these scenarios were complex, and it was uncertain whether the IRS would challenge their use. With the release of Notice 2014-54, the IRS has simplified the path.