As advisors, third-party administrators and recordkeepers digest the Internal Revenue Service's recently issued new rules on after-tax rollovers, experts continue to provide guidance on the rules, which IRA guru Ed Slott says is "new territory."
In its Notice 2014-54, released in mid-September, the IRS issued a new rule allowing participants in a 401(k), 403(b) or a 457 plan to take a distribution of after-tax money and convert it to a Roth IRA tax-free.
Slott, who runs IRAhelp.com, released in his October IRA Advisor newsletter detailed information about the new rule, which he told ThinkAdvisor in a previous interview answers "one of the most common, if not the most common, question that he gets from advisors."
He explains in his newsletter that the most important takeaway for advisors from the IRS notice "is clearly the ability for clients with both pre-tax and after-tax money in their employer plans, like 401(k) and 403(b) plans, to allocate the pre-tax and after-tax portions of plan distributions to different retirement accounts."
The notice says it will generally apply to distributions taken in 2015 or later, but "it also says taxpayers can apply a reasonable interpretation of the existing rules, including the guidance in this notice, so practically speaking, the guidance is effective immediately."
While the allocations of pre-tax and after-tax money described in Notice 2014-54 can theoretically be made to any type of retirement account, Slott continues, "the most beneficial for clients will be to allocate the pre-tax portions of a distribution to a traditional IRA rollover, while at the same time, allocating the after-tax portion of a distribution to a Roth IRA conversion. By doing so, clients will be able to retain the tax-deferred status on the pre-tax portions of their distributions and simultaneously convert only the after-tax portions of their plan distributions, tax-free."
Slott also points out that the Notice has "an additional benefit" for those with both appreciated employer stock in their plans, as well as after-tax funds.
For some time, a number of plan administrators have allowed clients to use after-tax money to reduce the taxable portion of a net unrealized appreciation (NUA) transaction (to offset the ordinary income tax owed on the cost of the shares) on a non-pro-rata basis. Now, says Slott, "it appears that argument is all but settled for good," as under Notice 2014-54, pre-tax money is allocated first to direct rollovers, next to 60-day rollovers and finally, to any amounts not rolled over. "If that's the case, then the reverse must also be true," Slott explains. "After-tax portions of a distribution must first be allocated to amounts not rolled over, then to 60-day rollovers and only after that to direct rollovers. Since, by definition, appreciated company stock is not rolled over in an NUA transaction, if the other plan assets (i.e., mutual funds) are rolled over – either via direct rollover or a 60-day rollover the after-tax funds have to be allocated to the NUA shares."
Slott says advisors should take note of the follwing seven facts about the new rule and its guidance:
