Do you contribute to a qualified retirement plan at work, such as a 401(k), 403(b) or 457 plan? Does your account have a large balance? If so, you’ll be glad to hear about a new IRS ruling that may give you a nice tax break in the future.
At some point in your life, you may want to roll the funds in that workplace retirement account into an IRA. If those dollars represent both pre-tax and after-tax contributions, wouldn’t it be nice to roll the pre-tax amounts into a traditional IRA and the after-tax amounts into a Roth IRA?
For years, the IRS discouraged this. In 2009, the IRS implicitly warned against such a move. At least that is how many tax advisors read IRS Notice 2009-68, which didn’t explicitly bar such “split” rollovers but strongly suggested they would raise red flags.
Still, some tax professionals saw “split” rollovers as doable with certain logistics. They advised their clients to withdraw the whole 401(k) balance as a first step and make outside funds available to counteract the resulting 20% income tax withholding. In other words, the plan participants wound up paying withholding on the distribution even though the goal was an IRA rollover.
Now the IRS has changed its mind. Starting January 1, 2015, you will be able to roll over after-tax dollars from a qualified retirement plan into a Roth IRA without paying taxes on the distribution. IRS Notice 2014-54 states this will now be permissible.
In fact, Notice 2014-54 says that “taxpayers are permitted to apply the proposed regulations to distributions made before the applicability date, so long as such earlier distributions are made on or after Sept. 18, 2014.” So it doesn’t frown on such a move before 2014 ends.
The IRS has really simplified things. Under Notice 2014-54 you can make a “split” rollover and have it count as one distribution instead of two. Also, the IRS is abandoning the pro rata tax treatment of such rollover amounts. Previously, if you had $100,000 in a qualified retirement plan and rolled $70,000 in pre-tax dollars into a traditional IRA and $30,000 in after-tax dollars into a Roth IRA, then 70% of the dollars going into each IRA would be taxed under the pro rata tax treatment. Under the new ruling, a plan participant can take the $30,000 of after-tax funds out of the plan and convert it to a Roth IRA tax-free.
This has to be done in one fell swoop. The IRS ruling does note that rollovers of pre-tax and after-tax dollars from a qualified retirement plan to IRAs must occur at the same time. If they don’t, they will be regarded as separate distributions. The IRS will understand “reasonable” administrative delays in this matter.
Do you have after-tax amounts in your 401(k), 403(b) or 457 plan? This is worth determining, because the IRS just opened the door to a tax-free Roth conversion for anyone who does.
About the Retirement Financial Advisor
Robert Pagliarini, PhD, CFP®, EA is passionate about helping retirees build the retirement of their dreams. He has over 25 years of experience as a retirement financial advisor and holds a Ph.D. in retirement planning. In addition, he is a CFP® Ambassador, one of only 50 in the country, and a real fiduciary. His focus is on how to help make retirement portfolios last decades while providing a steady source of income. When he's not helping people plan their retirement, he can be found writing his forthcoming book, The Retirement Myth: Escape Average Retirement & Create a High Performance Retirement. If you would like a second opinion to see if your retirement financial plan will keep you comfortable and secure, contact Robert today.