Moving your retirement money around is now easier than ever. In a conciliatory move for taxpayers, the IRS has issued new rules that allow you to minimize your tax liability when you move 401(k) funds into a Roth IRA or into another qualified employer plan. The situation arises when you have a retirement account through your employer that includes both pre-tax and after-tax funds. However, allocating your retirement funds to new plans becomes tricky upon leaving the company.
The new allocation rules took effect in 2015, but taxpayers chose to apply them to distributions as early as September 18, 2014, the date the new rules were released by the IRS.
Under the old rules, you would have to pro-rate distributions (plan-to-taxpayer) and rollovers (plan-to-plan) separately between pre-tax and after-tax amounts according to a set formula, resulting in payment of tax on a pro rata share of pre-tax funds. The new rules allow you to do the allocations yourself within certain limits. You can now choose to move pre-tax money into a traditional IRA and after-tax money into a Roth IRA. If you moved pre-tax amounts into a Roth IRA, you would have to pay tax on the rollover because Roths can only be funded with after-tax money. Now you can direct pre-tax dollars to one account and after-tax dollars to another to avoid tax liability.
Previous law treated a direct rollover from an employer plan to another qualified plan as one distribution and a distribution from an employer plan directly to a taxpayer as another, even if they occurred at the same time. This meant that each distribution had a separate allocation of pre-tax and after-tax amounts. The new rules allow taxpayers to treat a mix of direct rollovers (plan-to-plan) and indirect rollovers (plan to taxpayer to another account) as one transaction. The allocation then can be split by the taxpayer to avoid taxable distributions. In short, the new rules allow you to get your after-tax 401(k) money into a Roth IRA and put your pre-tax money into a traditional IRA and not pay taxes on the distribution. Sound confusing? It is.
Let’s look at an example.
An employee participates in a 401(k) through his employer. The account balance is $250,000, consisting of $200,000 in pre-tax amounts and $50,000 in after-tax amounts (that’s 4/5ths pre-tax, 1/5th after-tax). The employee leaves the company and requests a distribution of $100,000. Under the distribution rules, $80,000 of the $100,000 (4/5 of $100,000) is considered pre-tax money and the balance of $20,000 (1/5 of $100,000) is deemed to be after-tax money.
When the employee makes a direct rollover (plan to plan) of $80,000 to a traditional IRA and $20,000 to a Roth IRA, he can allocate the $80,000 pre-tax amount to the traditional IRA and designate the $20,000 after-tax amount to the Roth, thereby avoiding any tax on the shift of funds.
Before the rule change, in the example above, each rollover would be treated separately and would have to be apportioned between pre-tax and after-tax amounts, resulting in a tax liability on the transfer of the some of the money going in the Roth IRA.
The latest IRS regulations have made smart planning possible. It is now easier to move your after-tax money into a Roth IRA. This is a major benefit because Roth IRAs are the only retirement plans that grow tax-free. Earnings are never taxed if you follow the rules and wait until you are 59 ½ to withdraw the accumulated income in the account. The first step is to determine how much of your retirement savings is in after-tax versus pre-tax dollars. Then the planning can begin. Even though the rule changes simplify the process, retirement income planning is still complex and you should consult with your tax advisor to help you plan any change in your retirement plan accounts.