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IRS blesses split 401(k) rollovers

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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.

The solution

The new IRS rules allow a distribution from an employer-sponsored retirement account to be treated as a single distribution even if it contains both pre-tax and after-tax contributions, and even if those contributions are rolled over into separate accounts, as long as the amounts are scheduled to be distributed at the same time. The guidance now allows the taxpayer to allocate pre-tax and after-tax contributions among different types of accounts in order to maximize their future earnings potential, avoiding the pro-rata tax treatment discussed in the previous example.

This presents a best-of-both worlds solution for higher income clients who have sufficient funds so that they are able to make contributions in excess of the pre-tax limit (currently $17,500). If the specific plan allows for after-tax contributions, these taxpayers now have the freedom to contribute after-tax dollars with the knowledge that those funds can be separated and rolled directly into a Roth upon exiting the employer-sponsored plan, without tax liability.

Because higher-income clients’ direct Roth contributions are limited — or prohibited entirely — based on income level, this also presents a backdoor opportunity for creating a tax-free retirement income source for the future.

The new rules are effective for transactions scheduled to occur on or after January 1, 2015, but the IRS guidance allows clients to rely on the rules as of their release on September 18, 2014.

Conclusion

The new rules apply only to rollovers made from employer-sponsored plans, but for clients who have the means to make after-tax contributions, the potential for maximizing the value of these contributions can prove invaluable.