Recent guidance from the IRS (Notice 2014-54) is good news that should make it easier for defined contribution plan participants with pretax and after-tax amounts to split their accounts when taking distributions. The guidance makes Roth 401(k) accounts more attractive for participants and, as a result, employers who have not yet added Roth deferrals to their 401(k) plans may want to re-consider adding the Roth feature to their plans.
With an increase in the number of retirement plans that offer Roth after-tax contributions, more participants may be retiring with pretax and after-tax amounts in their plan accounts.
At distribution time, it is common for participants who have both pretax and after-tax amounts in their plan accounts to want to continue to defer tax on the pretax amount by directly rolling the pretax amount over to an individual retirement account (IRA) or other employer plan. At the same time, participants often want to receive the after-tax amounts in cash with no tax consequences.
In the past, the rules required that each distribution from a plan account had to include a pro rata share of both pretax and after-tax amounts. This made it hard for a plan participant to directly roll over the pretax portion and take the after-tax portion in cash.
There was a work-around solution, but it wasn’t easy. If a participant took an indirect rollover, instead of a direct rollover, that participant could accomplish the goal of rolling over the pretax amount. With an indirect rollover, distribution amounts are treated as consisting of pretax amounts first, rather than a pro rata share. But 20% withholding would apply, which means the participant would have to come up with money outside the plan account to make up for the withholding. Thus, while this approach was doable, it was not convenient.
Now, the IRS has changed the rules. The new rules assign the pretax amount to the direct rollover portion first. This allows participants to directly roll over the pretax portions. Any excess pretax amount is next assigned to any indirect rollover and remaining pretax amounts are taxable.
This is great! We love it when the IRS guidance is helpful for plan administrators and participants! Industry organizations had requested these changes and the IRS listened, understood, and made the change.
With this guidance and the earlier expansion of Roth in-plan rollovers, employers who permit pretax salary deferrals only may want to take another look at adding Roth deferrals to their plans. And let’s hope for more beneficial guidance like this from the IRS in the future!