IRS provides an exception enabling rollover to Roth IRA of tax-free part of distributions from qualified retirement plans
©2015 by Michael C. Gray
May 18, 2015
Roth IRAs provide a great opportunity to accumulate tax-free earnings. The fastest way to create a big Roth IRA is using a conversion from an employer retirement account. The toll the taxpayer pays for the conversion is any part of the amount converted to the Roth account that would be taxable to the account owner if received is current taxable income.
What if an employee doesn't want to pay the income tax to convert his or her taxable employer retirement account, but has made some non-deductible contributions to an employer qualified retirement account (such as a 401(k) account)?
The general rule for distributions from taxable retirement accounts when non-deductible contributions (the "after-tax amount") have been made to them is that a part of the distribution is taxable and another part is a non-taxable return of the non-deductible contribution. Some people call this the "cream in the coffee" rule.
Late in 2014, the IRS issued liberalized rules for when a distribution from an employer qualified retirement account is rolled over to multiple accounts, such as a Roth IRA account, another employer qualified retirement account and a "regular" (taxable) IRA. (In order to receive an after-tax amount, an employer qualified retirement account must keep track of the after-tax amount received.) The rules are described in IRS Notice 2014-54. Proposed regulations were issued at the same time, REG-105739-11 and NPRM REG-105739-11.
According to the Notice, the general "cream in the coffee" rule doesn't apply when the distribution is transferred to another employer qualified retirement account, an IRA or a Roth IRA in a direct trustee-to-trustee transfer or in a 60-day rollover.
The pretax amount and after-tax amounts for total distributions are still determined under the general rules, but the employee/account owner can direct how much of the distributions to each account represents pretax and after-tax amounts. Distributions to multiple accounts at the same time are aggregated and considered to be a single distribution.
If the pretax amount (representing what would have otherwise been taxable income if received) for a distribution is less than the amount directly rolled over to one or more eligible retirement plans, the entire pretax amount is assigned to the amount that is directly rolled over. If the direct transfer is made to more than one plan, the employee can select how the pretax amount is allocated among the plans that receive the distributions. The employee/account owner must give these instructions before the rollovers are done.
If the pretax amount exceeds the amounts directly rolled over to employer qualified plans or IRAs, the remaining amount is allocated up to the amount of 60-day rollovers.
If any pretax amount isn't allocated to the direct rollovers and the 60-day rollovers and cash is distributed to the employee (or beneficiary), that part of the distribution will be ordinary income.
In a nutshell, the employee/account owner now can designate what part of distributions received is an after-tax amount (up to the nondeductible contributions made) and what part is a pretax amount. The employee can direct after-tax amounts to a Roth IRA, and the conversion will not be subject to income tax and can accumulate future income tax-free. The employee can direct pretax amounts to a regular (taxable) IRA, there will be no current tax and future income will be tax-deferred and taxable when withdrawn from the account in the future.
For example, Jane Employee participates in an employer qualified plan. She has a $250,000 account balance, including a $200,000 pretax amount and a $50,000 after-tax amount. She separates from service and requests a distribution of $100,000. The pretax amount allocated to the distribution is $100,000 X $200,000 / $250,000 = $80,000. The after-tax amount is $20,000.
Jane can direct the plan administrator to directly transfer the $80,000 pretax amount to a regular IRA and $20,000 after-tax amount to a Roth IRA.
Be aware that distributions from an employer retirement account are subject to income tax withholding, so employees/account owners should avoid 60-day rollovers and make direct transfers. Otherwise the employee/account owner will have to add additional cash from his or her own funds to make up for the withholding.
For more information about Roth and traditional IRAs, buy our book: How to use Roth & IRA accounts to provide a secure retirement, 2012 Edition.
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