Recent IRS Regulations Simplify Roth IRA Rollovers
Roth IRAs are a popular choice for many individuals wanting to enjoy tax-free growth and distributions of their retirement savings. In addition, many 401(k) plan participants create separate designated Roth accounts within their plan to hold their designated Roth contributions.
Thanks to final regulations released by the IRS in 2016, it’s now easier and more efficient to transfer after-tax funds from designated Roth accounts to Roth IRAs or other designated Roth accounts. Many retirement savers will find this a plus because of the increased flexibility when it comes to making Roth IRA rollovers.
How were Roth account distributions previously taxed?
Designated Roth accounts generally include both after-tax funds — or contributions made by plan participants — and pretax funds, or earnings on investments. Previously, when distributions were made from designated Roth accounts, they were considered to include a pro rata share of both after-tax and pretax funds. In general, the after-tax distributions aren’t taxable, but the pretax distributions are.
When a distribution from a designated Roth account is rolled over, amounts directly rolled over are treated as distributions separate from amounts paid directly to employees. This is known as the “separate distribution rule.” Before the final regulations took effect, a distribution that was split between a direct rollover to an eligible retirement account and a direct payment to an employee was treated as two distributions. The after-tax and pretax amounts were separately allocated pro rata to each distribution.
The result was that employees couldn’t have the entire pretax portion of their distribution rolled over tax-free into a Roth IRA or designated Roth account. This is because some of the pretax portion of the distribution was considered to have been paid directly to the employee and thus subject to tax.
What does eliminating the separate distribution rule mean for you?
The final IRS regulations essentially eliminate the separate distribution rule. Rather than allocating the pretax amounts pro rata to the rollover and the employee payment, the pretax amounts will now be allocated to the rollover first. Thus, all of the pretax funds can now be allocated to the tax-free rollover, thus minimizing the amount that will be taxable when partial rollovers of nonqualified distributions are performed.
These final regulations are generally effective for distributions made on or after January 1, 2016.
Determining the best designated Roth account distribution and rollover options for your situation can be complicated. So be sure to contact your tax advisor to discuss your particular scenario in more detail.