IRS shifts course with new rollover distribution rule

The agency's latest guidance permits workers to roll over money tax-free

Sep 18, 2014 @ 1:45 pm

By Darla Mercado

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The Internal Revenue Service today provided guidance on the treatment of after-tax money inside a retirement plan, permitting workers to roll over those dollars tax-free into different destinations.

This morning, the IRS released Notice 2014-54, called “Guidance on Allocation of After-Tax Amounts to Rollovers,” that will affect distributions made on or after Jan. 1, 2015.

Above all, the new ruling permits savers to break out that after-tax portion of money within the retirement plan and convert it to a Roth IRA free of taxes.

This decision is a shift from where the IRS stood on eligible rollover distributions of money from a retirement plan when those dollars included after-tax contributions. Previously, there was a question among experts on how to best deal with the issue. Some experts thought that if an employee wanted to split his retirement savings, sending pretax dollars to one place (say, another retirement plan or a traditional IRA) and after-tax dollars elsewhere (like a Roth IRA), it required a series of steps to do so. Taxpayers needed to have enough money outside of the plan to cover the tax bill for the portion put into the Roth IRA, too. The treatment of after tax and pretax money was the subject of heated discussion in the tax expert community.

“In 2009-68, the IRS didn't say that you couldn't [split pre-tax and after-tax dollars into different vehicles], but they strongly alluded to the fact that you could not,” said Jeff Levine, a CPA and IRA technical consultant for Ed Slott and Co. “We've been waiting five years, and now the IRS says that yes, you can allocate that after-tax money to the Roth.”

There are hitches. For instance, advisers should not interpret the new ruling as a blessing from the IRS that clients can take money out of an IRA and convert it tax-free. This decision applies strictly to money within a company's retirement plan, noted Ed Slott, an IRA expert.

Advisers also should check in with clients to determine if they have after-tax money in their retirement plans, and if not, see if they can make such contributions. That will depend on the terms of the retirement plan the client is in, according to Mr. Levine, so check the summary plan description to make sure this is workable.

For the most part, this notice applies to high-earning employees who make enough money that they can sock away more than just the $17,500 maximum in their 401(k). “You can get into the plan more than that amount between the company match and the profit-sharing component,” Mr. Levine said.

Those top earners can — and do — kick after-tax money into their 401(k), depending on rules of the plan, he noted. In fact, the total amount of all contributions to defined contribution plans is $52,000, so top earners could benefit from tax-deferred savings on money that's already been subject to income taxes.

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