OK as promised here is what the experts I drilled at Heckerling said about the issue of whether or not direct transfer distributions from a QRP with basis are pro rata …

Louis Mezzullo: Said without hesitation they are pro rata.. ( as he gave me one of those looks that seemed to say I should know that)

Marcia Chadwick Holt… Said they are pro rata and made a good point of saying to look at Roth Qualified plans. THey come out pro rata unlike a ROTH IRA. The reason being that distributions come out of QRP pro rata ..end of story.

Natalie Choate.. For Natalies answer please read the email conversation below. I asked her this question last September and I am now posting it because she gave me her permission to do so. The answer is quite insightful:

From the Contact Us form at Ataxplan.com

Date sent: September 12, 2008 at 8:55
Name: Charles Lore
Company:

Comments: Natalie…I looked for a good hour in your book and could not find an answer to this question…

If a particiapnt has 1,000,0000 in a QRP ( profit sh/ 401k) and 800,000 is pretax … 200,000 after..Can he roll into a traditional ira the 800m and CONVERT the 200m to Roth?

The root of the question is does the QRP have to afdhere to pro-rata rule on distributions as would an IRA ( the book didnt seem to anwer this)

Lets assume plan would allow the ONLY the pre tax to be rolled to regular ira and will keep the 200m in th eplan until 2010 when he can do Roth..

If paln al;lows this can he in 2010 convert aftert tax to Roth ?

Dear Charles,
There is a good reason why I ducked that question in the book. I can’t figure out the answer. The Code (section 402(c)) has a nutty provision regarding this point when money is rolled from a QRP to an IRA (see emphasis):

c) RULES APPLICABLE TO ROLLOVERS FROM EXEMPT TRUSTS

(1) EXCLUSION FROM INCOME

If–

(A) any portion of the balance to the credit of an employee in a
qualified trust is paid to the employee in an eligible rollover
distribution,

(B) the distributee transfers any portion of the property
received in such distribution to an eligible retirement plan,
and

(C) in the case of a distribution of property other than money,
the amount so transferred consists of the property distributed,

then such distribution (to the extent so transferred) shall not be
includible in gross income for the taxable year in which paid.
[ok so far so good, a distribution is nontaxable if rolled over]

(2) MAXIMUM AMOUNT WHICH MAY BE ROLLED OVER

In the case of any eligible rollover distribution, the maximum amount
transferred to which paragraph (1) applies shall not exceed the
portion of such distribution which is includible in gross income
(determined without regard to paragraph (1)). The preceding sentence
shall not apply to such distribution to the extent–

(A) such portion is transferred in a direct trustee-to-trustee
transfer to a qualified trust or to an annuity contract
described in section 403(b) and such trust or contract provides
for separate accounting for amounts so transferred (and earnings
thereon), including separately accounting for the portion of
such distribution which is includible in gross income and the
portion of such distribution which is not so includible, or

(B) such portion is transferred to an eligible retirement plan
described in clause (i) or (ii) of paragraph (8)(B).
[ok, still so far so good, nontaxable amounts can be rolled to a QRP or 403(b) plan only via direct rollover; now we get to the tough part:]

In the case of a transfer described in subparagraph (A) or (B), the
amount transferred shall be treated as consisting first of the
portion of such distribution that is includible in gross income
(determined without regard to paragraph (1)).”

If you can figure out what the highlight provision in the preceding paragraph means please let me know. It seems to say when there is a direct rollover out of a qualified plan, the amount transferred is treated as consisting “first” of the portion that would have been taxable if the distribution were not rolled over. Well suppose your facts, a $1 million QRP of which $200,000 is after tax. Suppose a direct rollover of $800,000 to an IRA. If $800,000 were distributed to the participant and not rolled over, the “cream in the coffee rule” (proportionate rule) would apply, so 80% of the distribution ($640,000) would be considered pretax money and 20% ($160,000) aftertax. Now instead of being distributed it is rolled over directly to an IRA….so the $800,000 distribution is deemed to consist “first” of money that would be included in income if not rolled over, so it consists “first” of the $640,000 that would have been taxable if this had been a distribution not a rollover….and the rest is therefore deemed to consist of the nontaxable money? So what? That’s still proportionate….$640,000 deemed taxable and $160,000 nontaxable….just the same as if this special clause were not in the Code at all.
So what 402(c) MUST mean is that the distribution is deemed to come first out of the part of the account that would be taxable if the entire account were distributed. If that’s what it means, then you could roll the $800,000 pretax money, first, to a traditional IRA, tax-free, then convert the remaining $200,000 from the QRP to a Roth directly tax-free. And that’s what 402(c) MUST mean, since its literal meaning makes no sense at all. And I’m told some qualified plan providers will code any distribution the way the employee wants. But all of this is not QUITE the same as having direct support in the Code!
Let me know if the above makes sense.
Natalie

Natalie B. Choate, Esq.
Ataxplan Publications
c/o Nutter McClennen & Fish LLP
155 Seaport Boulevard WTCW
Boston MA 02210-2604
617-439-2995
[email protected]
http://www.ataxplan.com

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