Separating after tax from before tax funds in T-IRAs
My question has to do with separating before tax and after tax contributions to a traditional IRA in order to convert the after tax portion to a ROTH IRA.
BACKGROUND:
Last year, I was made aware of
Internal Revenue Bulletin: 2009-39
September 28, 2009
Notice 2009-68
Safe Harbor Explanation — Eligible Rollover Distributions
This is available at http://www.irs.gov/irb/2009-39_IRB/ar14.html.
In short, this bulletin says when an employer plan contains a mix of before tax and after tax contributions, any distribution the custodian makes must contain pro-rata fractions of before and after tax funds. It negates the practice of employer plans making custodian-to-custodian transfers (direct transfers) that send the before tax portion to one new custodian (say, a traditional IRA) and the after tax portion to another new custodian (say, a ROTH IRA). I called one of the authors, Mr. Michael Brewer at the IRS (see the “Drafting Information” paragraph in the cited document). He said this is not a new ruling but a clarification the Congressional language in the legislation for Qualified Plans and therefore applies to employer plans as well as traditional IRAs. I asked him if there was any way an after tax contribution I made in 2002 (note the year, it will be important in a minute) to my employer plan could be separately moved into a ROTH IRA and my before tax contributions and earnings be moved to a traditional IRA or my government employees Thrift Savings Plan. He said “Yes. You can do it via a 60-day rollover.” And he directed me to the SPECIAL RULES section of that same document – the relevant part is quoted below.
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SPECIAL RULES AND OPTIONS
If your payment includes after-tax contributions
After-tax contributions included in a payment are not taxed. If a payment is only part of your benefit, an allocable portion of your after-tax contributions is generally included in the payment. If you have pre-1987 after-tax contributions maintained in a separate account, a special rule may apply to determine whether the after-tax contributions are included in a payment.
You may roll over to an IRA a payment that includes after-tax contributions through either a direct rollover or a 60-day rollover. You must keep track of the aggregate amount of the after-tax contributions in all of your IRAs (in order to determine your taxable income for later payments from the IRAs). If you do a direct rollover of only a portion of the amount paid from the Plan and a portion is paid to you, each of the payments will include an allocable portion of the after-tax contributions. If you do a 60-day rollover to an IRA of only a portion of the payment made to you, the after-tax contributions are treated as rolled over last. For example, assume you are receiving a complete distribution of your benefit which totals $12,000, of which $2,000 is after-tax contributions. In this case, if you roll over $10,000 to an IRA in a 60-day rollover, no amount is taxable because the $2,000 amount not rolled over is treated as being after-tax contributions. You may roll over to an employer plan all of a payment that includes after-tax contributions, but only through a direct rollover (and only if the receiving plan separately accounts for after-tax contributions and is not a governmental section 457(b) plan). You can do a 60-day rollover to an employer plan of part of a payment that includes after-tax contributions, but only up to the amount of the payment that would be taxable if not rolled over.
QUESTIONS:
1. While the IRS author of the Bulletin told me I could use this special rule wrt my 2002 after tax contribution, the folks at my custodian T Rowe Price said they are skeptical because there is ambiguity in that the first paragraph might mean there is another special rule for pre-1987 after tax contributions, or it might mean the special rule in the next paragraph applies only to pre-1987 contributions. Mr. Brewer (IRS) said it applied to my 2003 contribution, but the T Rowe Price people said I had better make sure. So that is my first question. DOES THIS SPECIAL RULE APPLY TO AFTER TAX CONTRIBUTIONS IN GENERAL, OR ONLY TO PRE-1987 AFTER TAX CONTRIBUTIONS?
2. Since this IRS Bulletin was written in the first place because the legislation applies to all qualified plans and not just employer plans (that is, without distinction between employer plans and IRAs), DOES THIS SPECIAL RULE APPLY TO TRADITIONAL IRAs? Can after tax contributions in a traditional IRA be separated by taking a 60-day rollover of all traditional IRA funds from as many such IRA accounts as an individual may have, and then first moving all but the after tax amount shown on his/her IRS Forms 8606 to another (or same?) traditional IRA, and secondly moving the remaining after tax amount to a ROTH IRA?
Permalink Submitted by Alan Spross on Tue, 2011-01-25 04:18
1) This rule is actually contained in Sec 402(c)1 and 402(c)2 of the tax code. It does not matter when you made your after tax contribution to the employer plan, if you receive a distribution from that plan that includes after tax and pre tax amounts and then do IRA indirect rollovers, the amounts rolled over first are deemed to be the pre tax amounts. This applies to all after tax contributions. Therefore, if you desire to isolate your basis in a QRP distribution, you must do an indirect rollover (ie amounts received by the EMPLOYEE), replace any mandatory 20% withholding, and complete the TIRA rollover before rolling the remaining after tax amounts to a Roth IRA.
There is a separate rule under which pre 1987 after tax contributions can be distributed separately from a QRP. Therefore, if you have these contributions in your plan, you can request that they be distributed separately, and then you can roll them to a Roth IRA since there are no pre tax amounts included. Of course, if you are still employed, the character of any distributions you receive are subject to what the plan permits to be distributed. Pro rating only applies to amounts the plan actually distributes, and it can be avoided by doing the tandem indirect rollovers.
Unfortuneately, there is ambiguity in the IRS 2009 Notices that the American Benefits Council and other employee benefit firms have been pleading for clarification from the IRS, but no response yet, and no accompanying guidance to plan administrators on how to issue their 1099R forms to properly reflect this ruling. Therefore, it appears that many employees who did direct rollovers in the last 3 years will probably escape the consequences of the 2009 rulings.
As long as you are doing the indirect rollovers, you are in the clear. Is Price your IRA custodian? If so, they have no control over this situation because you report the amount of your conversion that is taxable, and custodians do not assign basis to IRAs. If Price is your QRP plan administrator, no matter what they show on the 1099R, you control where the basis goes per 402(c)1 and 2 by doing the rollovers in the correct order. In summary, this should not be a problem.
2) Short answer here is No. This order of rollovers does not apply to distributions from IRAs, only from QRPs. But another portion of the tax code indicates that if you roll an IRA distribution to a QRP, the QRP is not allowed to accept any after tax dollars so obviously the pre tax amounts are considered the first to be rolled to a QRP. Taxpayers are using this provision to remove the pre tax amount in their IRA leaving behind only 8606 basis, which they can then convert tax free and the 8606 Inst are very clear in producing this result.
But with respect to IRA to IRA rollovers, there is no ordering rules and everything is pro rated, so there is no way to isolate the basis to enable a tax free Roth conversion. You can only accomplish this by working for an employer whose QRP will accept incoming rollovers from your IRA.
Example: Your IRA has 20% basis per 8606. You distribute 10,000, and roll over 6,000. The rollover is reported on line 15 and the 4,000 retained includes 3,200 which is taxable. The other 800 is tax free and reduces your 8606 basis by that amount. If you convert the 4,000, same result ie 3,200 is taxable.
Permalink Submitted by Edward Stuebing on Tue, 2011-01-25 15:01
Many, many thanks!