In proposed regulations and Notice 2014-54, the Treasury Department and the Internal Revenue Service have revised the manner in which the after-tax amounts credited to a Roth account under a 401(k), 403(b) or governmental 457(b) plan may be rolled over to a Roth account in another employer plan or to a Roth IRA. Under the special allocation rules previously in effect for after-tax amounts, a participant receiving a distribution that consisted of a pre-tax amount and a Roth account after-tax amount could be prevented from rolling over the pre-tax amount of the distribution to another employer plan or a traditional IRA and separately rolling over the after-tax amount to a Roth IRA. Subject to certain conditions, this distribution-splitting technique is now permissible.
Since 2009, special rules required that a distribution from a 401(k), 403(b) or governmental 457(b) plan of after-tax amounts comply with allocation requirements where the distribution was to be separated into distinct components. Generally, if a distribution included both amounts that were to be directly rolled over to another plan or IRA and amounts payable to the participant, or if a distribution was intended to be split between two IRAs, the after-tax amount of the distribution had to be allocated between the separate parts of the distribution. These allocation rules effectively prevented participants from directing that the entire pre-tax portion of the distribution be directly rolled over to another employer plan or traditional IRA, and that the entire after-tax portion be rolled over to a Roth IRA.
Changes to Allocation Rules
Effective Jan. 1, 2015 (or beginning on or after Sept. 18, 2014, if elected by a participant), distributions that include after-tax amounts will be subject to a modified set of allocation requirements. Under the new requirements, if the pre-tax amount of a distribution to a participant is less than the total distribution to be directly rolled over, he or she can select how the pre-tax amount will be allocated if the rollover is being made to two separate plans or IRAs. Now the participant can roll over the pre-tax amount of a distribution to another employer plan or traditional IRA and separately roll over the after-tax amount to a Roth IRA. This option is available if the participant informs the plan administrator of this allocation before the direct rollovers occur.
A different rule applies where the pre-tax amount of the distribution equals or exceeds the amount of the distribution that is directly rolled over. In that case, the pre-tax amount is allocated first to the amount of the direct rollover so that the direct rollover consists entirely of pre-tax money. The remaining pre-tax amount is assigned to any “non-direct” rollovers (i.e., rollovers made by the participant within 60 days of receiving a distribution). If, after assignment of pre-tax amounts to the direct rollover and non-direct rollover, there is any remaining pre-tax amount unallocated, that remainder is included in the participant’s taxable income.
A major benefit of the new rules will be the ability to choose one rollover target for pre-tax money and a different rollover target for Roth money. For example, an employee changing jobs could send the pre-tax money to the new employer’s plan and set up a new Roth IRA for the Roth money.
Plan administrators will need to be aware of these rules for purposes of reporting on Form 1099-R distributions of pre-tax and after-tax amounts that will be separately rolled over. For example, a direction by a participant to have the pre-tax portion of a distribution rolled over to another employer’s 401(k) plan and the after-tax Roth amount paid directly to the participant would generally need to be reported on two separate Forms 1099-R.
In addition to the reporting issues raised by these new rules, participant communications should be reviewed to determine what revisions may be necessary. For example, the Section 402(f) notice that participants are required to receive in connection with a distribution will need to be modified to eliminate the prior rules on pro-rata allocation of after-tax amounts where a distribution will be split into separate rollovers.