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IRS Issues Proposed Rules on Allocation of After-tax Amounts from Roth Accounts
Practical Law Legal Update 8-581-7907 (Approx. 5 pages)
IRS Issues Proposed Rules on Allocation of After-tax Amounts from Roth Accounts
by Practical Law Employee Benefits & Executive Compensation
| Published on 23 Sep 2014 • USA (National/Federal) |
The Internal Revenue Service (IRS) issued proposed rules that would remove the current allocation rule and treat distributions from a Roth account made to multiple destinations as a single distribution beginning on January 1, 2015. In conjunction, the IRS issued Notice 2014-54 which explains the new allocation rules for after-tax and pre-tax amounts.
On September 18, 2014, the Internal Revenue Service (IRS) issued proposed rules that would remove the current allocation rule and treat distributions from a designated Roth account made to multiple destinations as a single distribution beginning on January 1, 2015 (79 Fed. Reg. 56310 (Sept. 19, 2014)). In conjunction, the IRS issued Notice 2014-54, which explains the new allocation rules for after-tax and pre-tax amounts.
Background
A Roth 401(k) account or designated Roth account combines elements of both a Roth IRA and a traditional 401(k) plan. The designated Roth account:
- Does not limit participation by income, unlike the Roth IRA.
- Allows participants to contribute on an after-tax basis, like the Roth IRA, up to the amounts permitted under a traditional 401(k).
Generally, an amount distributed from a designated Roth account is taxable to the participant, unless the amount is rolled over into an eligible account that is not taxable (see Practice Note, Roth 401(k) Plans: Distributions from Roth 401(k) Accounts and Rollovers to Other Roth Accounts). Under the current rules, if a designated Roth account includes both after-tax and pre-tax amounts, each distribution from the account will include a pro-rata share of both after-tax and pre-tax amounts.
A participant may elect to distribute one amount from a designated Roth account to multiple destinations. For example, a participant may roll over a portion of the amount to an eligible account and distribute the other portion to himself. Under the current rules, each portion is treated as a separate distribution (Treas. Regs. §1.402A-1, Q&A-5(a)). Consequently, under IRS Notice 2009-68, each distribution includes a pro-rata share of the after-tax and pre-tax amounts.
Proposed Rules
The IRS issued the proposed rules in response to comments received on Notice 2009-68 indicating confusion among plan providers regarding the application of the allocation rule and what happens when a participant distributes pre-tax and after-tax funds to multiple destinations.
Previously, providers were determining whether a distribution to multiple destinations should be treated as separate distributions or a single distribution. Commenters indicated that by treating distributions to multiple destinations as a single distribution, some plan providers were allowing participants to distribute the after-tax amount to one destination and the pre-tax amount to another.
As a result of these comments, the proposed rules remove the current allocation rule and treat a distribution made to multiple destinations as a single distribution if the distribution is made either:
- On or after January 1, 2015.
- On an earlier date chosen by the taxpayer that is on or after September 18, 2014.
These regulations are proposed to apply to distributions from designated Roth accounts made on or after January 1, 2015. Taxpayers may rely on the proposed regulations for distributions that are made on or after September 18, 2014 before the regulations are finalized.
Notice 2014-54
In conjunction with the proposed rules, the IRS also released Notice 2014-54, which offers new guidance on the allocation of after-tax and pre-tax amounts between distributions made to multiple destinations. When a distribution is made to multiple destinations:
- If the pre-tax amount is less than the amount of the distribution that is directly rolled over to one or more plans, the entire pre-tax amount is applied to the directly rolled over amount. If the direct rollover is to two or more plans, then the recipient can pick how the pre-tax amount is allocated among the plans prior to the time of the direct rollovers.
- If the pre-tax amount equals or exceeds the amount of the distribution that is directly rolled over to one or more plans, the pre-tax amount up to the amount of the direct rollover is applied to the directly rolled over amount and any remaining pre-tax amount is next assigned to any 60-day rollovers (rollovers that are not direct rollovers).
This guidance will apply to distributions made on or after January 1, 2015. The IRS also intends to revise the special tax notice under IRC Section 402(f).
Even though certain multiple disbursements to different destinations are treated as a single aggregated distribution, each disbursement may be required to be reported on a separate Form 1099-R in accordance with the instructions to Form 1099-R.
Update: On December 23, 2014, the IRS included two FAQs on Notice 2014-54 in its Employee Plans E-mail in response to numerous questions that it has received. These FAQs explain that a retirement plan participant:
- May not roll over only the after-tax amounts in his retirement plan account to a Roth IRA and leave the remaining amounts in the plan (a partial distribution of the after-tax amounts). Notice 2014-54 does not alter the requirement that each distribution from a retirement plan must include a proportional share of the pre-tax and after-tax amounts in the account. Therefore, any partial distribution from the plan must include some of the pre-tax amounts in the plan account ‒ a plan participant cannot take a distribution of only the after-tax amounts and leave the pre-tax amounts in the plan. Instead, a plan participant can roll over all of his after-tax contributions to a Roth IRA by taking a distribution of all pre-tax and after-tax amounts in his account, roll over all the pre-tax amounts in a direct rollover to a traditional IRA or another eligible retirement plan and then roll over all the after-tax amounts in a direct rollover to a Roth IRA.
- May roll over his after-tax retirement plan contributions to a Roth IRA and roll over earnings on his after-tax contributions to a traditional IRA. Earnings on after-tax contributions are pre-tax amounts in a retirement plan account. Therefore, after-tax contributions can be rolled over to a Roth IRA without also including earnings. Under Notice 2014-54, all pre-tax amounts in a distribution may be rolled over to a traditional IRA and will not be included in income until distributed from the IRA.
Practical Impact
Previously, there was a complicated mechanism that participants used in order to distribute after-tax and pre-tax amounts to multiple destinations. This mechanism was confusing among practitioners and providers, and resulted in much disagreement. This long awaited revision and guidance will provide practitioners and providers with more comfort and a simplified process so that after-tax and pre-tax amounts can be distributed to multiple destinations.