Aftertax dollars from qualified plans prove difficult to segregate.
Tucked quietly into an obscure IRS notice is a landmine for anyone trying to segregate aftertax dollars from a qualified plan distribution.
Many older retirement plan participants, especially those of large employers, have managed to accumulate significant aftertax funds in their employer retirement plans. These aftertax balances can become quite large, and they are usually the result of forfeitures, re-characterizations of excess contributions, or just additional contributions.
The most common way to handle these aftertax amounts was to split the distribution into a direct rollover to an IRA of the pretax amount and cut a check for the aftertax amount. The 1099-R for the distribution would reflect the amount of pretax dollars rolled over and the amount of aftertax dollars distributed directly to the participant. A direct rollover of pretax funds to an IRA is not subject to the 20% mandatory withholding requirement and is not a taxable event. The direct distribution of aftertax contributions to the participant was also not a taxable event thus did not require any withholding.
Another option would be to distribute the entire plan balance to the participant. The participant could then roll over the pretax funds to an IRA within 60 days and keep the aftertax funds. There is no difference in tax treatment for amounts rolled over into an IRA via a direct rollover than from amounts distributed to the participant, and then rolled into an IRA within the 60-day timeframe. The catch here is that taxable amounts distributed directly to the participant are subject to a mandatory 20% withholding. This meant that the participant would have to replace the 20% withheld from other sources within 60 days or the withheld amount withheld would be considered to be a taxable distribution.
Direct Rollover to a Roth IRA
This seemed to create a brand new, exceptional planning opportunity in 2010 for those leaving retirement plans (or folks able to take in-service distributions before retirement) and who have significant aftertax balances. Instructing the plan administrator to split the balance into pretax and aftertax portions, then rolling the pretax funds directly to an IRA and the aftertax funds directly to a Roth IRA was beginning to look like a great planning strategy for 2010 due to the elimination of the income limits for Roth conversions. If it worked, it would have allowed retirees to by-pass the Pro-rata rule and convert just the aftertax dollars in their plan to a Roth IRA.
The Opportunity Lost
IRS Sect.402(f) requires that plan trustees provide written notice to the recipients of plan distributions that describe "in plain language" all their various rollover options. To facilitate this requirement, the IRS produced Notice 2009-68 in September 2009. This notice provides sample language that plan fiduciaries can rely upon as a Safe Harbor to fulfill this notice requirement. Buried in this routine notice is one little section that seems to rewrite the actual tax code, without the assistance of Congress:
"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 aftertax contributions.
If you do a 60-day rollover to an IRA of only a portion of the payment made to you, the aftertax 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 aftertax 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 aftertax contributions."