Taxpayers now have the option to designate which accounts pretax and aftertax contributions from 401(k), 403(b) or 457(b) plans are disbursed to. Bowing to pressure and acknowledging a lack of compliance with previous regulations, the Internal Revenue Service issued new proposed rules slated to take effect on January 1, 2015. Taxpayers can use the new rules as guidance for distributions taken on or after September 18, 2014.

The rule changes apply to taxpayers who have made both pretax and aftertax contributions to an employer-sponsored qualified retirement plan. Under the previous regulations, partial distributions were assigned a prorated amount of pretax and aftertax dollars. In other words, if a taxpayer rolled over part of his or her retirement savings to an IRA and kept the remainder, both distributions would split proportionate to the amount of pretax and aftertax dollars previously held in the account.

The IRS acknowledged that this led to a multi-step process to get around the rule. The taxpayer would first take the eligible rollover as a cash distribution. Then he or she would roll over the pretax amount included in the distribution to an IRA. The remaining amount, consisting entirely of aftertax dollars, could then either be kept by the taxpayer or deposited into a Roth IRA.

This multi-step process is no longer necessary. Prior to taking the rollover, the taxpayer can simply give the plan administrator directions for assigning the distributions. Assignments to multiple accounts must be given in advance of the rollover. If the pretax amount is less than the amount of the distribution that is directly rolled over to one or more eligible accounts, the entire pretax amount is assigned to the portion of the distribution that is rolled over. If the pretax amount exceeds the amount of the distribution rolled over, the pretax amount first goes to the rollover and any remaining pretax amount is assigned to a 60-day window where it must be either invested in a qualified investment account or taxes will be due on it.

Examples of various scenarios are given in IRS Notice 2014-54. We suggest consulting a tax professional for additional clarification and for questions regarding the new rules.

Source: “Guidance on the Allocation of After-Tax Amounts to Rollovers, Notice 2014-54,” Internal Revenue Service, September 18, 2014.

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