New Guidance Opens the Door to Tax-free Roth IRA Conversions of Certain Retirement Funds

Thursday, September 18, 2014

By Jeffrey Levine, IRA Technical Expert
Follow on Twitter: @IRAGuru4EdSlott

Moments ago the IRS released new guidance – IRS Notice 2014-54 – regarding distributions from company retirement plans when there are both pre and post-tax money in those accounts. For years now, one question has plagued both plan participants and financial advisors alike… “If someone has a 401(k) with pre and post-tax money, can they take a distribution and roll (convert) just the post-tax money to a Roth IRA tax-free, while rolling the remaining pre-tax money over to a traditional IRA?”

Now, IRS has answered that question with a resounding YES!

Consider the following example:

John Doe has been working for ABC Enterprises for many years and has accumulated a $250,000 balance in his traditional 401(k). $25,000 of his total 401(k) balance consists of after-tax funds, while the remaining $225,000 is pre-tax money. Note that these are not Roth 401(k) funds, but rather, after-tax funds held in the traditional side of his plan. Now, John is getting ready to retire and wants to figure out what to do with his money.

If John wants to, he can leave his money in his plan. Alternatively, he could roll his entire plan balance over to an IRA, but that probably wouldn’t make much sense. Instead, he should probably have the $225,000 of pre-tax money sent directly to a traditional IRA or other tax-deferred retirement account while, at the same time, have the $25,000 of after-tax money go right to a Roth IRA, for a tax-free Roth conversion. Doing so would provide for a 100% tax-free conversion and allow any future growth on those funds to be distributed tax-free as well if they are part of a qualified distribution.

One key point to remember… the guidance from Notice 2014-54 does NOT apply to the pro-rata tax rule for IRAs (including SEP and SIMPLE IRAs). That rule has NOT changed.

Here’s the link to the entire IRS Notice: http://www.irs.gov/pub/irs-drop/n-14-54.pdf

 

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