On September 18, the Internal Revenue Service (IRS) issued Notice 2014-54, which clarifies that, subject to some limitations, a single distribution of pre-tax and after-tax amounts from a qualified retirement plan, a 403(b) plan, or a governmental 457(b) plan may be split and allocated to different destinations.
Generally, when a participant’s qualified plan or 403(b) or 457(b) plan account includes both pre-tax and after-tax amounts, each distribution must contain a pro-rata allocation of these amounts. The IRS’s most recent model rollover notice, which was issued in 2009, suggested that participants could not direct pre-tax and after-tax amounts to separate destinations without applying the pro-rata allocation rule with respect to the amount sent to each location. For example, under the model notice’s approach, if a participant directly rolled over a portion of his or her account and took a cash distribution of a portion of his or her account, both the portion that was directly rolled over and the cash distribution had to contain a pro-rata allocation of pre-tax and after-tax amounts.
In practice, however, some plan sponsors and recordkeepers allowed participants to direct pre-tax and after-tax amounts to separate destinations, despite the wording in the model rollover notice. In part, this was allowed because participants could have accomplished essentially the same result by taking a single cash distribution, and then rolling over the pre-tax portion of the distribution into a traditional individual retirement account (IRA) within 60 days. The remaining after-tax funds could then be rolled into a Roth IRA or kept for personal use.
Under Notice 2014-54, effective January 1, 2015, all simultaneous disbursements from qualified retirement plans and 403(b) or 457(b) plans will be treated as a single distribution. Therefore, participants will be able to direct pre-tax and after-tax amounts to separate destinations without requiring proration with respect to the amounts directed to each destination, subject to the following rules:
- If the pre-tax portion of the amount distributed is less than the amount the participant chooses to roll over directly, the entire pre-tax amount is allocated to the direct rollover. If amounts will be directly rolled over to more than one location, the participant can choose the pre-tax allocation between the direct rollover destinations by informing the plan administrator in advance.
- If the pre-tax portion of the amount distributed exceeds the amount the participant chooses to roll over directly, any remaining pre-tax amounts are assigned to 60-day rollovers (that is, rollovers that are not direct rollovers), if any. If pre-tax amounts are rolled over to two or more destinations in the 60-day rollovers, the participant can choose how the pre-tax amounts are allocated between the 60-day rollover destinations.
- Any pre-tax amounts remaining after any direct rollovers and 60-day rollovers (i.e., amounts taken in cash) must be included in the participant’s gross income for the tax year of the distribution.
For example, a participant who has $100,000 invested in his or her employer’s qualified retirement plan ($20,000 after-tax and $80,000 pre-tax) would like to roll over $60,000 directly to an IRA and keep $20,000 for personal use. Under the new guidance, this transaction is treated as a single distribution totaling $80,000 ($16,000 after-tax and $64,000 pre-tax). In this example, the entire amount of the direct rollover ($60,000) is treated as pre-tax. The remaining $20,000 kept for personal use is treated as $4,000 pre-tax (which is subject to tax in the year of the distribution) and $16,000 after-tax.
The guidance issued in Notice 2014-54 becomes effective on January 1, 2015. For periods before January 1, 2015, the Notice permits a reasonable interpretation of the statutory rollover rules, which would include allowing pre-tax and after-tax amounts to be directed to separate destinations. Plan administrators using the IRS model rollover notice or a notice with similar language may consider revising their rollover notices to reflect the new guidance.