IRS eases rules for retirement plan rollovers

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.

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 your first designated contribution and after you turn age 591/2 or because of your 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. You can designate some or all of your elective deferrals as designated Roth account contributions, in lieu of traditional, pretax 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, if you’re age 50 or older, $24,000 vs. $6,500). Plus Roth IRA contributions are subject to income-based phaseouts, which may reduce or eliminate your ability to contribute.

Distributions from designated Roth accounts may be rolled over only to another designated Roth account or a Roth IRA. Rollovers from one designated Roth account to another must be direct.

The allocation dilemma

Designated Roth accounts generally include both after-tax amounts (contributions) and pretax amounts (investment earnings). Each distribution is considered to include a pro rata share of after-tax and pretax amounts. Generally, nonqualified distributions of after-tax funds aren’t taxable, but nonqualified distributions of pretax 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 regs, if a distribution from an employee’s designated Roth account was split between a direct rollover to an eligible retirement account and a direct payment to the employee, it would be treated as two distributions, with the pretax and after-tax amounts separately allocated pro rata to each distribution.

As a result, an employee couldn’t choose to have the entire pretax 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 pretax portion would be considered to have been paid directly to the employee and, therefore, be subject to tax.

The new allocation rules

The final regs make things significantly easier for taxpayers. They eliminate the requirement that a designated Roth account distribution that’s 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 pretax amounts pro rata to the rollover and the employee payment, the pretax amounts will be allocated first to the rollover.

This minimizes the amount that will be taxable if you do a partial rollover of a nonqualified distribution. Now, all of the pretax funds can be allocated to the tax-free rollover.

For example, let’s say you leave a job and take a $14,000 nonqualified distribution from your designated Roth account. The distribution includes $11,000 of your after-tax contributions, which aren’t subject to tax, and $3,000 of pretax earnings on the account, which is taxable. To avoid tax on the $3,000 you’d need to roll over at least that amount to a Roth IRA.

If you roll over $7,000 of the distribution to a Roth IRA within 60 days, that amount is considered to consist of $3,000 of pretax earnings and $4,000 of your after-tax contributions. The $7,000 that you don’t roll over is deemed to be all after-tax funds, and therefore the entire distribution is tax-free.

Transition rules

The regs also address the allocation of pretax 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 regs 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. We can help you determine which designated Roth account distribution and rollover options are right for you.