PRO RATA RULE .. rules!
http://www.leimbergservices.com/membersonly.cfm?nl=lis_ebr_511
It looks like the great Qualified Plan Pro Rata Distribution debate may be put to rest. IRS Notice 2009-68 says a partial distribution from a QP is deemed pro rata. If you have 100,000 in a QP with 60000 pre tax and 40000 after tax you cannot direct roll the 60m to a TIRA and have 40m sent home without income taxes owed. It is now clear that each distribution has both pre tax and after tax money and the 40m sent home would have some withholding just for good measure.
Hats off to Marcia Holt who called this correctly when I asked her last yr at Heckerling.
Permalink Submitted by Alan Spross on Wed, 2010-01-20 02:49
I am not so sure that this is totally put the rest. At least the American Benefits Council is not comfortable with certain inconsistencies in 2009-68. The attached is a letter they sent to the IRS on 10/31/09 and I am not aware that they have a reply so far:
http://www.americanbenefitscouncil.org/documents/402f_notice_abc-cmnts_1…
It would be real nice to see in black and white the handling of basis with tandem direct rollovers, with the pre tax to a TIRA and the post tax to a Roth IRA. That would seem to be the most popular type of distribution pattern for former employees and even current employees who are allowed in service distributions. The IRS does not seem to grasp what type of rollovers will be in demand.
We all understood how the indirect rollovers should be handled because that is in the tax code in Sec 402(c) since 2002. But for the direct rollovers the question remains whether 402(c) was meant to apply to them also…….or not.
Edit addition: Chuck, I just sent the author of that letter an email inquiring if she has received a response from the IRS yet. Will advise.
Permalink Submitted by [email protected] on Fri, 2010-01-22 14:53
What about a situation where the individual does a rollover/conversion of the after-tax money to a Roth IRA? We have clients who are considering this and after reading Notice 2009-68 I am starting to question whether the approach most plan adminstrators have taken is correct. For example, one plan adminsitrator is insisting that they are correct in how they code the 1099-Rs. For example, they actually showed us a case where they did a direct rollover of the before tax money (Code G Box 7 on 1099-R) and did not withhold. They then issued another 1099-R showing the after-tax dollars as non-taxable with a Code 1 (early distribution, no known exception). The individual then requested the custodian to do a rollover/conversion of the after-tax dollars held in a money market account the custodian set up for them. Using this approach, the plan adminstrator did not do the distributions pro rata on the 1099-R.
Now you see, the custodian and plan adminstrator are insistent that this is the approch to use and they are actually quoting the American Benefits Council letter saying that the IRS is wrong in making a distinction between an indirect rollover and a direct rollover. But my argument is that in the situation described above, the indivual did take “receipt” of the after-tax dollars because those dollars were desposited into a money market account. Notice 2009-68 suggests that this approach constitutes a partial rollover and the participant will be subject to the pro rata rule. Only the indirect 60-day rollover approach for BOTH transactions will be honored and of course the 20% mandatory withholding applies. The IRS needs to clear this up and provide clear instructions. In the meantime, we are going to recommend the conservative approach and if a client wants to do the more aggresive approach, we will have a letter stating that we are not to be held responsible if the IRS provides guidance to the contrary. The letter will state that that we informed the client of the two approaches.
I think what is going on is that the IRS has not questioned the 1099-Rs if they are coded the way described above and that since plan administrators have not been questioned on this, they keep doing it this way. In other words, the likelihood of discovery from the IRS has been low to non-existent. But with Notice 2009-68 and with the American Benefits Council letter, now there may be guidance and I think now more than ever you have to be careful because you could do a partial rollover (as described above) and then mid-stream the IRS says you can’t do that and the plan adminstrator issues a 1099-R shoiwng the prorata rule and then the client would be furious.
Any thoughts?
Permalink Submitted by Alan Spross on Fri, 2010-01-22 17:44
I agree with your overall view of the current situation. The IRS has been remiss in not clarifying this issue sooner, particularly before the 1099R forms are issued. While the IRS is unlikely to challenge a 1099R in many situations, I still would not be comfortable feeling home free with a 1099R that ignored pro rate rules. There is always a possibility of revision and recharacterization to eliminate any tax bill on the conversion, making it possible for the IRS to make a late ruling with minimal taxpayer damage.
At this point, I am not leaning either way on the final determination. For those who can afford to replace the 20% withholding on the pre tax amount of a distribution, they should proceed with the only clear way to do a tax free conversion, and that is by indirect rollover and then rolling the pre tax amount to a TIRA before rolling the after tax amount to a Roth IRA. Proceeding in this manner should provide considerable peace of mind, and lost cash flow on the withholding is not worth much at current interest rates anyway.
Permalink Submitted by Matthew Frederick on Sat, 2010-01-23 04:17
What about the scenario where an active participant has after-tax dollars in a current 401(k) where their only allowed in-service withdrawal is the after-tax source (under 59 1/2)? They contributed $30k after-tax over the last few years and the value of that source is $32k today. The participant requests and the plan distributes the entire $32k after-tax balance (basis + earnings) directly to a Roth IRA. Would there be any issue with this other than the participant being liable for the taxes on the $2k of earnings?
Permalink Submitted by Alan Spross on Sat, 2010-01-23 04:56
If the plan contains a specific provision for in service distributions that limits those distributions to a certain class of contributions or earnings, the 1099R should reflect that and the pro rate rules would be superceded. These special provisions would cease after separation from service.
There is also an IRS rule that allows pre 1987 after tax contributions to be separately distributed as long as the plan accounts for them separately. In this case, the distribution would not include any earnings on those contributions.
Permalink Submitted by Matthew Frederick on Sat, 2010-01-23 21:40
What if participant has the same scenario (in-service) but has $150k of post-86 after-tax basis and $350k of earnings attributable to that which is available to withdraw? Could they roll earnings to TIRA and convert basis to Roth. Plan is with Hewitt & Assoc. that would directly roll the $350k earnings to a TIRA and pay the $150k basis to the participant. The participant would subsequently deposit the $150k into a Roth IRA and have the custodian code it as a conversion. Would this trigger pro-rata calculation for both the rollover to TIRA as well as the conversion to Roth? In other words, would the individual now have basis in both accounts (cream in both cups of coffee) subject to 8606 going forward?
Assuming this is also unclear or that the IRS ultimately gives guidance that this would indeed trigger pro-rata status for both TIRA and Roth IRA, could the individual do the following?:
1) Roll entire $500k into TIRA (only IRA) and subsequently roll all taxable amounts in that TIRA back to their current employer plan (which we’ll assume plan allows) and leave only after-tax basis of $150k in TIRA.
2) Convert $150k (+ 2009/2010 non-deductible contribution) immediately to Roth IRA.
3) in 2011 roll back the rollover source + earnings, if any, to the same TIRA (plan allows in-service withdrawal of rollover source).
This would appear to be better than the indirect rollover with 20% withholding on the taxable amount of $350k ($70k) that they would have to come up with out of their own pocket and deposit within 60 days to complete the rollover back to TIRA as has been discussed earlier in this post.
Thanks!
Permalink Submitted by Alan Spross on Mon, 2010-01-25 02:02
It is up to the plan administrator to issue their 1099R forms in compliance with the plan provisions. If the plan specifies that only certain types of distributions are allowed while still in service, their 1099R should reflect the tax status of any distributions. If different segments are allowed to be distributed, then the pro rate rules should apply to those segments. So this leaves us with the original unresolved question of whether direct rollovers enjoy the same advantage as indirect rollovers in allowing the pre tax dollars to be the first dollars rolled over.
Your work around strategy that also avoids the mandatory withholding problem would work. The only challenge is having your current plan accept all pre tax dollars in your TIRA accounts, even if all your TIRA accounts are not conduit IRAs. Once you get the plan to accept the rollover, the rest is easy.
Permalink Submitted by Matthew Frederick on Wed, 2010-03-03 01:01
Fairmark.com posted an article last week on this issue that further clarifies this issue but seems to contradict my previous post/question regarding in-service withdrawal of AT amounts where there is little to no earnings and it is the only source available from plan.
http://fairmark.com/rothira/09030801-401k-basis.htm
Any thoughts?
Thanks!
Permalink Submitted by Alan Spross on Wed, 2010-03-03 02:03
The article is an excellent summary of the current “unstable” situation and various approches that have different chances of success. However, it does not address distributions from plans that allow segregated in service distributions of contributions of various types. It does not make sense to apply pro rate rules to amounts that can not and do not come out of the plan. Plan accounting would never match up with taxpayer accounting were that to be the case.
Another issue not addressed in the article is the type of fallout expected when plan administrators have no better understanding of the distribution consequences than the taxpayer. The 402f Notice is now sadly lacking in the details needed for it to fulfill it’s intended purpose. That said, the IRS is unlikely to question the 1099R issued by the plan since it should reflect proper plan accounting and provisions. Therefore, if your 1099R shows the % of after tax dollars that you expect, the only thing for the IRS to question then is your rollover reporting on your 1040. The article covered those issue fairly well.
That said, the entire situation is unstable as Kaye Thomas indicated, particularly since the IRS has issued some surprising rulings in recent years.