As part of ThinkAdvisor’s Special Report, 23 Days of Tax Planning Advice: 2016, throughout the month of March, we are partnering with our ALM sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

1. What is an eligible retirement plan for purposes of the rollover rules?

The definition of “eligible retirement plan” depends on the plan from which a rollover is made. An eligible retirement plan with respect to a distribution from a qualified plan means an IRA, another qualified plan, a Section 403(a) annuity, a Section 403(b) tax sheltered annuity, and an eligible Section 457 governmental plan (provided it agrees to separately account for funds received from any eligible retirement plan except another eligible Section 457 governmental plan). 

Non-Roth IRAs (traditional, SEP, and SIMPLE). An eligible retirement plan with respect to a distribution from a non-Roth IRA (an individual retirement account or an individual retirement annuity) means an IRA, a qualified plan, a Section 403(a) annuity, an eligible Section 457 governmental plan (provided it agrees to separately account for funds received from any eligible retirement plan except another eligible Section 457 governmental plan), and a Section 403(b) tax sheltered annuity. Amounts paid or distributed out of a SIMPLE IRA during the first two years of participation may be rolled over only to another SIMPLE IRA. The only rollover permitted to a SIMPLE IRA is from another SIMPLE IRA.

Roth IRAs. A distribution from a Roth IRA generally can be rolled over only to another Roth IRA. A rollover or conversion from a non-Roth IRA or other retirement plan into a Roth IRA generally is a taxable event.

Section 403(b) annuity. An eligible retirement plan with respect to a distribution from a Section 403(b) tax sheltered annuity includes a non-Roth IRA, a qualified plan, a Section 403(a) annuity, an eligible Section 457 governmental plan (provided it agrees to separately account for funds received from any eligible retirement plan except another eligible Section 457 governmental plan), and another Section 403(b) annuity.

(Related: Mark Your Calendars: Key Tax Planning, Filing Dates in 2016)

Eligible Section 457 governmental plan. An eligible retirement plan with respect to a distribution from an eligible Section 457 governmental plan includes a non-Roth IRA, a qualified plan, a Section 403(a) annuity, another eligible Section 457 governmental plan and a Section 403(b) annuity.

2. What new rules apply to allow a taxpayer to rollover pre-tax and after-tax contributions in a qualified plan into separate accounts in a single distribution?

The IRS now allows 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, so long as the amounts are scheduled to be distributed at the same time. The new rules allow 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 below.

This creates a planning opportunity for higher income taxpayers who have sufficient funds so that they are able to make contributions in excess of the pre-tax limit ($18,000 in 2016). If the specific plan allows for after-tax contributions, these taxpayers can 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 additional tax liability.

Prior regulations permitted a distribution to be rolled partly into a traditional account and partly into a Roth, but the taxpayer 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 taxpayer’s distribution of $100,000 consisted of $80,000 in pre-tax contributions and $20,000 in after-tax contributions, the taxpayer 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%) so that 80 percent of the Roth transfer would be taxed.

3. Must a participant receiving an eligible rollover distribution have the option of making a direct rollover to another qualified plan?

Yes.

All qualified plans, a Section 403(b) tax sheltered annuity, and an eligible Section 457 governmental plan must provide a participant receiving an eligible rollover distribution the option to have the distribution transferred in the form of a direct rollover to another eligible retirement plan. This direct rollover option generally must be provided to any participant receiving a distribution.

A direct rollover is defined as an eligible rollover distribution (see above) that is paid directly to an eligible retirement plan for the benefit of the distributee. A direct rollover may be accomplished by any reasonable means of direct payment, including the use of a wire transfer or a check that is negotiable only by the trustee of the eligible retirement plan. Giving the check to the distributee for delivery to the eligible retirement plan is considered reasonable provided that the check is made payable to the trustee of the eligible retirement plan for the benefit of the distributee. Certain amounts may be rolled over only in the form of a trustee-to-trustee transfer. Plans are not required to accept rollovers, direct or otherwise.

If a participant’s total distribution is expected to be less than $200, the participant need not be offered the option of a direct rollover. While a participant must be permitted to elect a direct rollover of only a portion of the distribution, a plan administrator may require that this direct rollover portion equal at least $500. In the case of Section 403(b) tax sheltered annuities, the payor of the eligible rollover distribution is treated as the plan administrator.

A plan administrator is not required to permit a participant to make a direct rollover of only a portion of the distribution if the full amount of the distribution totals less than $500. A plan administrator may permit a participant to divide the distribution into separate distributions to be paid to two or more eligible retirement plans in direct rollovers but is not required to do so. (see above)

If an eligible rollover distribution from a qualified retirement plan, tax sheltered annuity, or eligible governmental 457 plan is not handled by means of a direct rollover, the distribution will be subject to a mandatory income tax withholding rate of 20 percent.

Plans subject to the direct rollover rules are required to provide that a cash-out distribution in excess of $1,000 and less than $5,000 will automatically be transferred to an individual retirement plan unless the distributee affirmatively elects to have it transferred to another eligible retirement plan or elects to receive it directly.

4. If a rollover is not made through a direct rollover, must income tax be withheld from the distribution?

Distributions from qualified retirement plans, tax sheltered annuities, and eligible Section 457 governmental plans are subject to a mandatory income tax withholding rate of 20 percent unless the transfer is handled by means of a direct rollover. An employee receiving a distribution may not elect out of the withholding requirement. Distributions from traditional IRAs are not subject to mandatory 20 percent withholding.

If a participant receives an eligible rollover distribution that is subject to the 20 percent withholding rate, the 20 percent withheld will be includable in income even if the participant rolls over the remaining 80 percent of the distribution within the sixty day period. Because the amount withheld is considered to be an amount distributed under those sections, the participant may add an amount equal to the 20 percent withheld to the 80 percent he or she has received, resulting in a rollover of the full distribution amount.

Where a distributee elects to transfer a portion of the distribution by a direct rollover and receive the remainder, the 20 percent withholding requirement applies only to the portion of the distribution that the distributee actually receives. It does not apply to the portion of the distribution that is transferred directly to another eligible retirement plan.

5. May an individual who is not a participant in a qualified plan roll over amounts received from the plan by reason of a divorce or separation agreement?

Yes, if the agreement is a qualified domestic relations order (“QDRO”) and certain requirements are met.

A QDRO is a decree or judgment under state domestic relations law that recognizes or creates the right of a spouse or child to receive, or to have set aside, a portion of a participant’s interest in a qualified plan, 403(b) plan, or eligible Section 457 governmental plan.

If an alternate payee who is the spouse or former spouse of the participant receives a distribution by reason of a QDRO, the rollover rules apply to the alternate payee as if the alternate payee were the participant. Thus, the alternate payee can avoid the requirement of including the distribution in income to the extent any portion of an eligible rollover distribution is directly rolled over or rolled over to an eligible retirement plan within sixty days.

A qualified retirement plan may be an eligible retirement plan for an alternate payee who is a spouse or former spouse of the participant and who receives the distribution by reason of a QDRO. This kind of rollover must be handled through a direct rollover to avoid a mandatory income tax withholding rate of 20 percent. There are separate rules applicable to surviving spouses.

QDRO rules do not apply to IRAs. An IRA, however, can be transferred tax-free in connection with a divorce if the correct procedure is followed. In such cases, the transfer of an individual’s interest in an IRA or an individual retirement annuity to a spouse or former spouse under a divorce or separation instrument is not considered a taxable transfer made by the individual, and such interest at the time of the transfer is treated as the spouse’s IRA and not such individual’s IRA. Thereafter the account or annuity will be treated as maintained for the benefit of the spouse.

See ThinkAdvisor’s complete tax planning home page: 23 Days of Tax Planning Advice: 2016.

Related: Mark Your Calendars: Key Tax Planning, Filing Dates in 2016