RETIREMENT TIPS: IRS Clarifies IRA Rollover Rules

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AlanKondo-238x300By ALAN KONDO, CFP, CLU

For 2015, the maximum pre-tax money that you can contribute to an employer-sponsored plan, such as a 401(k), 403(b) or 457, is $18,000 ($24,000 if you are age 50 or over). For many people, this ceiling is adequate.

However, for some high-income employees, even the maximum contribution is not enough to build a nest egg sufficient to maintain their lifestyle in retirement. For this reason, they often contribute an additional after-tax amount to their retirement plan.

The problem came when they decided to retire. Ideally these employees would want to roll the pre-tax portion of their contributions to a Traditional IRA, and the post-tax portion to a Roth IRA. The IRS, however, was inconclusive about whether this was allowed.

After years of ambiguity, the IRS ruled definitively in September of 2014 that participants in employer-sponsored retirement plans can roll after-tax contributions into a Roth IRA tax free.

IRS Notice 2014-54, Guidance on Allocation of After-Tax Amounts to Rollovers, “provides rules for allocating pretax and after-tax amounts among disbursements that are made to multiple destinations from a qualified plan.”¹ Importantly, the notice states that all disbursements from a retirement plan made at the same time will be treated as a single distribution even if they are sent to multiple new accounts.

Prior to this ruling, the IRS treated distributions from a retirement plan that were rolled over to multiple new accounts as separate distributions, each requiring that a proportional share of pretax and after-tax monies be disbursed.²

A Simplified Process

Now individuals holding both pre-tax and after-tax amounts in their plan can transfer — through direct, trustee-to-trustee rollovers — the pretax portion of the distribution (including earnings on after-tax amounts) to a traditional IRA and the after-tax portion of the distribution to a Roth IRA. In the past, this could only be accomplished through indirect 60-day rollovers, not through simplified direct rollovers.²

More Clarification, Please

As with many IRS rulings, Notice 2014-54 raised many questions with taxpayers. In response, the IRS recently issued some answers to those commonly asked.

Q: If I have both pretax and after-tax monies in my retirement account, can I roll over just the after-tax monies to a Roth IRA, leaving all of the pretax monies intact?

A: No, the new rule does not change the requirement that partial distributions from a plan must include a “proportional share” of the pretax and after-tax amounts.

Example: If your account balance is $100,000 and consists of $80,000 in pretax amounts and $20,000 in after-tax amounts, and you request a distribution of $50,000, your distribution would consist of $40,000 of pretax amounts and $10,000 of after-tax amounts.²

In order to roll over all of your after-tax contributions to a Roth IRA, you must take a full distribution (all pretax and after-tax amounts), roll over all the pretax amounts directly to a traditional IRA or another eligible retirement plan, and roll over all the after-tax amounts directly to a Roth IRA.

Q: Can I roll over my after-tax contributions to a Roth IRA and the earnings on my after-tax contributions to a traditional IRA?

Yes, since earnings on after-tax contributions are considered pretax monies, after-tax contributions can be rolled over to a Roth IRA while the earnings on those contributions can be directed to a separate traditional IRA and avoid being taxed until they are distributed.

Plan Sponsors: A New Opportunity

The new guidelines present an opportunity for plan sponsors to reach out to participants to determine which individuals have after-tax money in their plans and explain the new rules — and the new opportunity — to them. Further, for those participants who are not currently making after-tax contributions, advisors may want to encourage them to do so, if their employer plan allows.

High-earning employees who are not making after-tax contributions are missing out on the chance to sock away significantly more while benefiting from lower income taxes and tax-deferred investment growth. See your Certified Financial Planner™ or CPA for guidance on the best asset allocation and IRA rollover strategy for you.
¹ The Internal Revenue Service, Notice 2014-54, Guidance on Allocation of After-Tax Amounts to Rollovers, Sept. 18, 2014.

² The Internal Revenue Service, Employee Plans News, Dec. 23, 2014.

The opinions expressed above are solely those of Kondo Wealth Advisors, Inc. (626-449-7783 [email protected]), a Registered Investment Advisor in the state of California. Neither Kondo Wealth Advisors, Inc. nor its representatives provide legal, tax or accounting advice.

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