The IRS has released taxpayer-friendly final regulations regarding certain retirement plan rollovers. Specifically, the new rules should make it easier — and less costly — to transfer after-tax funds from designated Roth accounts to Roth IRAs or other designated Roth accounts.
The Fruitful Advantages of Roth IRAs and Designated Roth Accounts
Roth IRAs can grow tax-free and have no required minimum distributions (RMDs) until after the owner’s death, leading to the potential for a greater accumulation of savings. Qualified distributions to the owner or the owner’s heirs are also tax-free. A qualified distribution is generally one that occurs at least five years after the first designated contribution and after the owner turn age 59 1/2 or because of the owner’s disability or death.
Designated Roth accounts are separate accounts in a 401(k), 403(b), or governmental 457(b) plan that hold an employee’s designated Roth contributions. Account holders can designate some or all of their elective deferrals as designated Roth account contributions in lieu of traditional, pre-tax elective contributions — if the plan allows such contributions.
As with a Roth IRA, employee contributions to a designated Roth account are includable in gross income, but qualified distributions (as defined above) from the account are tax-free. Even though designated Roth accounts have RMDs during their owners’ lifetimes, they also have significantly higher annual contribution limits than Roth IRAs (for 2016, $18,000 vs. $5,500 or$24,000 vs. $6,500 for those age 50 and older). Plus, Roth IRA contributions are subject to income-based phaseouts, which may reduce or eliminate the ability to contribute.
Distributions from designated Roth accounts may be rolled over only to another designated Roth account or a Roth IRA. Note: Rollovers from one designated Roth account to another must be direct.
The Growing Allocation Dilemma for Retirement Plan Rollovers
Designated Roth accounts generally include both after-tax amounts (contributions) and pre-tax amounts (investment earnings). Each distribution is considered to include a pro rata share of after-tax and pre-tax amounts. Generally, nonqualified distributions of after-tax funds are not taxable, but nonqualified distributions of pre-tax funds are.
Under the “separate distribution rule,” when a distribution from a designated Roth account is rolled over, any amount directly rolled over is treated as a distribution separate from any amount paid directly to the employee. Before the new allocation requirements, if a distribution from an employee’s designated Roth account were split between a direct rollover to an eligible retirement account and a direct payment to the employee, then it would be treated as two distributions, with the pre-tax and after-tax amounts separately allocated pro rata to each distribution.
As a result, an employee could not choose to have the entire pre-tax portion of a distribution rolled over tax-free into the Roth IRA or designated Roth account (from which it could eventually be distributed tax-free). In other words, some of the pre-tax portion would be considered to have been paid directly to the employee and, therefore, be subject to tax.
The “Budding” Allocation Rules for Retirement Plan Rollovers
The final regulations make things significantly easier for taxpayers. They eliminate the requirement that a designated Roth account distribution that is split between a direct rollover to an eligible retirement plan and a direct payment to the employee be treated as separate distributions. Rather than allocating the pre-tax amounts pro rata to the rollover and the employee payment, the pre-tax amounts will be allocated first to the rollover.
This stipulation minimizes the amount that will be taxable if an employee does a partial rollover of a nonqualified distribution. Now, all of the pre-tax funds can be allocated to the tax-free rollover.
For example, let’s say an individual leaves a job and takes a $14,000 nonqualified distribution from his designated Roth account. The distribution includes $11,000 of his after-tax contributions, which are not subject to tax, and $3,000 of pre-tax earnings on the account, which is taxable. To avoid tax on the $3,000, he would need to roll over at least that amount to a Roth IRA.
If an employee rolls over $7,000 of the distribution to a Roth IRA within 60 days, that amount is considered to consist of $3,000 of pre-tax earnings and $4,000 of after-tax contributions. The $7,000 that is not rolled over is deemed to be all after-tax funds, and therefore the entire distribution is tax-free.
Cultivate the Right Options for Your Employees’ Retirement Plan Rollovers
The rules also address the allocation of pre-tax and after-tax amounts that are included in distributions from a designated Roth account that are directly rolled over to multiple destinations (for example, a Roth IRA and another designated Roth account). The new rules are complex, but they also make it easier to minimize tax on such distributions.
The final mandates generally are effective for distributions made on or after January 1, 2016. Taxpayers may, however, elect to apply them for distributions on or after September 18, 2014, and before January 1, 2016. Contact CRI if you need assistance determining which designated Roth account distribution and retirement plan rollover options are right for you.