The Internal Revenue Service (IRS) recently released guidance on the allocation of pre-tax and post-tax amounts distributed from a tax-qualified plan under Internal Revenue Code (Code) Section 401(a), a Code Section 403(b) plan or a governmental plan under Code Section 457(b) (collectively “Tax Favored Plans”). The new guidance is effective January 1, 2015; however, for distributions made on or after September 18, 2014, plan sponsors may apply a reasonable interpretation of the allocation rules for Roth amounts, other after-tax amounts and pre-tax amounts distributed to multiple locations. For distributions made prior to September 18, 2014, plan sponsors may apply a reasonable interpretation of the allocation rules, except that a distribution made from a designated Roth account prior to September 18, 2014, must be allocated in accordance with the Roth regulations as in effect on the date of the distribution.
In connection with this change, the IRS issued revised safe harbor rollover notices for use by plan administrators of Tax Favored Plans. The revised model notices can be found here and may be used immediately to satisfy the notice requirements under Code Section 402(f), provided that the notices should be revised by plan administrators to reflect any applicable changes in the law after December 8, 2014. The guidance accompanying the notices also describes changes that should be made to the existing model notices to reflect tax law changes since 2009.
On and after December 8, 2014, plan administrators who rely on the safe harbor rollover notices must use the revised notices.
As a general rule, for purposes of determining the amount includible in the recipient’s gross income, a distribution from a participant’s account that holds pre-tax and after-tax amounts must be deemed to include a pro rata share of pre-tax and after-tax amounts. In addition, prior IRS guidance suggested that if a participant requested a distribution from an account and elected to have it transferred to multiple destinations (e.g., a direct rollover of a portion and cash distribution of the remaining amount), each disbursement was treated as a separate distribution subject to a pro-rata allocation of pre-tax and after-tax amounts.
Effective January 1, 2015, all simultaneous distributions from a Tax Favored Plan will be treated as a single distribution for purposes of determining the amount includible in the recipient’s gross income, regardless of whether it is disbursed to single or multiple destinations. Also effective January 1, 2015, distributions from accounts that contain pre-tax and post-tax amounts will be allocated first to pre-tax amounts (i.e., the distributee must include the amounts in gross income to the extent the amounts are not rolled over). Any remaining amounts are then treated as after-tax amounts that are not taxable to the distributee when received. As a practical matter, the after-tax amounts that are not taxable to the distributee, including tax free earnings on Roth amounts, are treated as the last amounts distributed.
For example, Tom has an account balance of $150,000 ($100,000 of pre-tax amounts and $50,000 of after-tax amounts) under his employer’s tax qualified retirement plan. Tom requests a distribution of $75,000, $45,000 of which will be directly rolled over to an IRA and $25,000 paid to him. Under the IRS’s new guidance, the disbursements are treated as a single distribution of $75,000 ($50,000 pre-tax and $25,000 after-tax). Because the pre-tax amount exceeds the amount directly rolled over, the entire amount of the direct rollover of $45,000 is treated as pre-tax and the remaining $25,000 not rolled over is treated as $5,000 pre-tax and $20,000 after-tax.
Revised Safe Harbor Rollover Notice
Under Code Section 402(f), recipients of eligible rollover distributions must receive advanced written explanation detailing, among other things, the conditions for a direct transfer of a distribution to an eligible retirement plan, the mandatory 20% withholding for amounts not directly transferred to an eligible retirement plan, the timing requirements for 60-day rollovers, and the circumstances where the distribution may be subject to restrictions and tax consequences, which are different from those applicable to distributions from the distributing plan. In 2009, the IRS issued two separate safe harbor rollover notices that are deemed to satisfy a plan administrator’s notice obligations under Code Section 402(f) ― one for payments from a designated Roth account and one for payments not from a designated Roth account. The new model notices update the previously issued safe harbor rollover notices to reflect changes in the law, including recent IRS guidance relating to new allocation rules for pre-tax and after-tax amounts and distributions in the form of in-plan Roth rollovers, and to make other clarifications.