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."
This language appears to eliminate the ability to split distributions and preserve the segregation of pretax and aftertax funds if any portion is being transferred directly to the IRA. What I find truly puzzling is that the plan administrators are distributing the Notice 2009-68 to their terminating participants, with the above language, but then telling their folks the exact opposite. They are saying that they will cut two checks, one for the pretax amount and one for the aftertax amount. The pretax check will be made out to a rollover IRA and the aftertax will be payable to the participant. It is implied that the check payable to the participant is all aftertax money. What is not said is that according to this notice, the above would be a partial direct rollover and the check payable to the participant would include a pro rata share of both pretax and aftertax amounts. The amount rolled over to the IRA would also contain pretax and aftertax funds requiring the filing of form 8606 each year from then on to track the aftertax funds in the rollover IRA.
If you read the above carefully, you'll come to the conclusion that the only way to preserve the segregation of pretax and aftertax funds is with a complete distribution and partial rollover within 60 days. This requires the plan to completely distribute the entire plan balance directly to the participant (subject to 20% withholding on the taxable amount), then within 60 days, the participant must rollover the taxable amount (plus funds to replace the withholding) to keep the aftertax funds separate. For those retiring with large balances, they may need to use the aftertax money to replace the 20% withheld and then must wait until next April for their tax refund.
Enter the Pro Rata Rule
Now, it would still be possible to fund a Roth IRA with the aftertax money, but it would have to be done the old fashioned way of funding a traditional IRA and then converting it. Alas, now the pro rata rule would apply to the amount converted which means that the converted funds would have the same proportion of pretax and aftertax dollars as the total of all the taxpayer's IRA accounts. For example, if the total qualified plan balance being distributed is $1 million and $100,000 is aftertax, then only 10% of the amount converted would be tax-free and 90% would be taxable in the year of conversion.
I have heard some planners advise that the above will work if the participant sets up an IRA with the aftertax funds and then converts it to a Roth IRA before rolling over the balance of the distribution into a regular IRA (Assuming there are no other IRA accounts). Unfortunately, this is misguided, since it will be the balance of all IRAs on Dec. 31 of the year of the conversion that is used to calculate the pro rata amount of aftertax funds in the conversion. Regardless of the order of these transactions, at the end of the year there will be a traditional IRA with $900,000 and a Roth IRA with $100,000 and tax due on $90,000 (90% of the amount converted).
Another faulty strategy making the rounds is to have the plan cut one check to the custodian for the benefit of the participant and then instruct the custodian to split the check into the pretax and aftertax amounts. The pretax dollars would be deposited into a rollover IRA and the aftertax dollars would be deposited into a Roth IRA. As far as the plan is concerned, this would not be a partial distribution, so Notice 2009-68 shouldn't come into play. However, the same issue with the pro rata rule exists. At the end of the year, the balances of all IRA accounts will be used to determine the proportion of pretax to aftertax dollars for the amount converted to the Roth.
If you are advising clients with aftertax balances in their employer's qualified plan, alert them to this issue where the IRS notice says one thing, but their plan administrators are saying something quite different. It almost seems that the administrators have not read the notice they are distributing. The tax ramifications could be significant, so be sure you understand them thoroughly.