Here’s the dilemma. You have a traditional 401(k) that contains both after-tax and pre-tax dollars. You’d like to receive a distribution from the plan, convert only the after-tax dollars to a Roth IRA, and roll the pre-tax dollars into a traditional IRA. (By rolling over/converting only the after-tax dollars to a Roth IRA, you avoid paying any income tax on the conversion.)
For example, let’s say your 401(k) plan account balance is $10,000, consisting of $8,000 of pre-tax dollars and $2,000 of after-tax dollars. Can you simply request a total distribution of $10,000, instructing the trustee to directly roll the $8,000 of pre-tax dollars to a traditional IRA and the remaining $2,000 of after-tax dollars to a Roth IRA?
In the past, many trustees allowed you to do just that. But in recent years the IRS had suggested that this result could be achieved only with indirect (60-day) rollovers, not direct rollovers. The legal basis for this IRS position was, however, not entirely clear. (The problem with indirect rollovers is that they are subject to 20% mandatory withholding and, if not executed correctly, could be fully taxable–and distributions prior to age 59½ might also be subject to a 10% federal income tax penalty.)
IRS Notice 2014-54
On September 18, in Notice 2014-54 (and related proposed regulations), the IRS backed away from its prior position. Based on the Notice, it is finally clear that employer-plan distributions can be split into more than one retirement vehicle with, for example, pre-tax money transferred directly to a traditional IRA (with no current tax liability) and after-tax money moved directly to a Roth IRA (with no conversion tax). Even though the new rules aren’t scheduled to go into effect until January 1, 2015, taxpayers can apply this guidance to distributions made on or after September 18, 2014. (The guidance also applies to 403(b) and 457(b) plans.)
Prior to Notice 2014-54, it was possible to achieve a tax-free Roth conversion of after-tax dollars in an employer plan, but it was a fairly complicated procedure using 60 day (indirect) rollovers, not direct rollovers, which involved several steps and required taxpayers to have sufficient funds outside the plan to make up the 20% mandatory withholding that applied to the taxable portion of the distribution. The ability to accomplish the same result in a more efficient manner using direct rollovers is welcome relief.IRS Notice 2014-54 is titled Guidance on Allocation of After-Tax Amounts to Rollovers, and can be found at www.irs.gov/pub/irs-drop/n-14-54.pdf.
Stacy Bush has practiced independent financial advising in the Valdosta area for 14 years. Growing up on a farm in Donalsonville, Georgia, he is keen to the financial needs of South Georgia and North Florida families. Stacy and his wife, Carla, live in Valdosta with their four children. You can submit questions about this article to email@example.com