Isolating Basis for a Roth Conversion
By Kaye A. Thomas
Current as of September 23, 2014
Isolating basis when taking money from an employer plan has become dramatically easier.
On September 18, 2014 the IRS published new guidance on allocation of after-tax amounts when making a rollover from a 401k or similar plan. You may benefit if you’ve made after-tax contributions (other than Roth contributions) to the retirement plan where you work.
This development changes the rules for rollovers from employer plans when the payout includes both pre-tax and after-tax dollars. Previously, if you wanted your pre-tax dollars to end up one place, such as a traditional IRA for a tax-free rollover, and your after-tax dollars to end up somewhere else, such as a Roth IRA for a tax-free conversion, you had to thread a path through rules so complicated that even the experts couldn’t always agree on what worked. Now, however, if you have after-tax dollars in an employer account and you’re able to take a rollover-eligible distribution, it’s a simple matter to send your pre-tax and after-tax dollars to different destinations.
This change affects accounts in employer plans, not IRA accounts. See below for links to related pages, including basis isolation for IRA accounts.
Who can benefit
You can benefit from this change in the rules if the following are true:
- You’ve made after-tax contributions to a 401k or similar plan where you work, and
- You’re able to take a distribution that’s eligible for rollover.
In an employer plan, after-tax dollars may be in a designated Roth account or in a non-Roth account (often called a traditional account). These new rules can be used when taking money from either type of account, but the benefit is greatest when you have after-tax dollars in a traditional account. In this case you can use these rules to move the money from an account where the investment earnings are tax-deferred (but taxable when withdrawn) to a Roth IRA, where the earnings will be entirely tax-free if you wait long enough.
Cream in the coffee
If you’ve made after-tax contributions to a traditional account in an employer plan, distributions from that account will generally include a blend of after-tax and pre-tax dollars. Natalie Choate, author of Life & Death Planning for Retirement Benefits, aptly calls it the “cream in the coffee” rule. If we send these blended payments to a traditional IRA, we’re still in a situation where investment earnings produced by the after-tax dollars are merely tax-deferred. If we send them instead to a Roth IRA, future investment earnings will be tax-free, but we have to pay tax on the pre-tax dollars included in the transfer. Ideally we’d like to separate the cream from the coffee, so that the pre-tax dollars can go to a traditional IRA (a tax-free rollover) and the after-tax dollars can go to a Roth IRA (a tax-free conversion). This would allow us to get our after-tax dollars from a tax-deferred account to a tax-free account with no up-front cost.
Prior to this new guidance, the IRS appeared to have taken the position that when funds are paid from a retirement plan to more than one recipient (such as a traditional IRA and a Roth IRA), we have to treat the payments as separate distributions. This position was explicit in the regulations dealing with distributions from designated Roth accounts. We had no explicit guidance on this issue regarding distributions from traditional accounts in employer plans, but no reason to believe the IRS position would be different. When payments are treated as separate distributions, each would consist partly of pre-tax dollars and partly of after-tax dollars, so the cream remains mixed with the coffee.
Example: Your 401k distribution is 80% pre-tax and 20% after-tax. You tell the company to pay 80% to your traditional IRA and 20% to your Roth IRA. If these are treated as separate distributions, each one is split 80-20 between pre-tax and after-tax, so 80% of the amount transferred to the Roth would be taxable.
Tax experts responded by inventing roundabout methods to achieve the goal of separating pre-tax and after-tax dollars. While some of these methods appeared to be legally sound, none was entirely satisfactory. In particular, one method required the 401k money to be paid to you individually and then rolled to separate IRAs. The problem here was mandatory income tax withholding on the initial distribution of pre-tax dollars because it went to you instead of going directly to an IRA. To complete the rollover within 60 days, you would need to come up with money from some other source to replace the dollars that were withheld.
The solution, part I
The solution provided in the September 2014 guidance comes in two parts. First, it abandons the position that separate recipients imply separate distributions, provided that payments are scheduled to occur at the same time:
For purposes of determining the portion of a disbursement of benefits from a plan to a participant, beneficiary, or alternate payee that is not includible in gross income under the rules of §72, all disbursements of benefits from the plan to the recipient that are scheduled to be made at the same time (disregarding differences due to reasonable delays to facilitate plan administration) are treated as a single distribution without regard to whether the recipient has directed that the disbursements be made to a single destination or multiple destinations.
Note the importance of scheduling the transfers to occur at the same time! If you make two separate transfers at different times, you don’t get the benefit of this change in the rules.
The solution, part II
In theory the IRS could say that even if these simultaneous transfers are treated as a single distribution, each piece of it has to be treated as a mix of pre-tax and after-tax dollars. The new guidance eliminates this concern. Speaking of a situation where a direct rollover goes to more than one retirement plan, it says:
[I]f the direct rollover is to two or more plans, then the recipient can select how the pretax amount is allocated among these plans. To make this selection, the recipient must inform the plan administrator of the allocation prior to the time of the direct rollovers.
Note the importance of telling the company in advance which dollars (pre-tax or after-tax) are going to which IRA! This may seem like a trivial matter, but you haven’t followed the rules if you simply say, “Pay $30,000 to my traditional IRA and $10,000 to my Roth.” You need to say, “Pay the pre-tax dollars to my traditional IRA and the after-tax dollars to my Roth.”
Using the New Basis Isolation Rules
A step-by-step explanation of how to use the new rules to move after-tax dollars from an employer plan to a Roth IRA.
Isolating IRA Basis
What if your after-tax dollars are in an IRA instead of an employer plan? The rules are different.
See below for links to other pages dealing with this topic
Remember the two critical requirements stated above: the transfers have to be simultaneous, and you have to tell the plan administrator how you’re allocating the pre-tax and after-tax dollars between the two payments. See the links below for related information.
This page was completely revised after the IRS issued guidance in September 2014.
- Isolating Basis for a Roth Conversion
- Using the New Basis Isolation Rules
- Isolating IRA Basis
- Basis Recovery from Employer Plans
- Separate Subaccount Treatment
- Simple Payout
- Using an IRA to Isolate 401k Basis
- Split Rollover Methods