Reviewed or updated February 8, 2018
Explanation of the legal basis for separate subaccount treatment of post-1986 after-tax contributions to employer plans.
There is some confusion as to the availability of separate subaccount treatment for after-tax contributions to employer plans. This page explains why this treatment is (or should be) generally available.
To understand the legal authorities we need to know how the following terms are used.
- Employee contributions. We tend to think of both pre-tax and after-tax contributions to a 401k account as employee contributions. In the tax law, however, pre-tax contributions are elective deferrals, and as a technical matter these contributions are made by the employer, not by the employee. When the tax law refers to employee contributions, it is talking about after-tax contributions.
- Separate contract. The rules for recovering basis in an employer plan are connected with rules for recovering basis in an annuity, and they use annuity terminology. In a situation where it would be more natural to refer to a separate account or subaccount, these rules refer to a separate contract. There is no distinction in meaning. When applying these rules to an account-based retirement plan (such as a 401k), treating an amount as a separate contract means the same as keeping it in a separate account or subaccount.
With that much terminology under our belt we can present section 72(d)(2) of the Internal Revenue Code:
For purposes of this section, employee contributions (and any income allocable thereto) under a defined contribution plan may be treated as a separate contract.
This rule, created by the Tax Reform Act of 1986, initially appeared as section 72(e)(9) of the Code and applied only “for purposes of this subsection” — that is, subsection (e), which deals with amounts not received as annuities. In a technical correction it was moved to section 72(d) and, as you see, applies “for purposes of this section,” meaning all of section 72. This was because Congress intended to make this separate contract treatment (in other words, separate subaccount treatment) available for payments both before and after the annuity starting date (see page 724 of the General Explanation of the Tax Reform Act of 1986 (big PDF).
The law changed again in 1996. The rules for taxing annuity payments were seen as overly complicated, and Congress put a simplified method into effect (section 72(d)(1)). It appears that the IRS interprets this change as overriding the effect of the previous technical correction, so that separate subaccount treatment for after-tax contributions applies only to amounts not received as annuities. This distinction is of little importance for our purposes because amounts received as annuities generally aren’t eligible for rollover, and therefore aren’t eligible for a Roth conversion.
Annuity vs. separation from service
One point of apparent confusion concerning this rule is its availability after a separation from service. Some have the mistaken impression that separate account treatment is available only for in-service distributions. There is no such restriction, however. A distribution after a separation from service is eligible provided that it is not received as an annuity. The definition of “received as an annuity” is quite narrow. For example, if you’ve elected to have your account paid out over a fixed number of years, but retain the right to demand an accelerated payment, this ability to accelerate prevents your payments from being treated as received as an annuity. Citations to relevant authorities can be found in LTR 200243054 (PDF).
Shall be or may be
The original version of this rule said these amounts shall be treated as a separate contract. In the technical correction mentioned earlier, the language was changed so that they may be treated as a separate contract. It seems likely that this change was made because employers had very little time from the date the law was enacted (October 1986) to the date it took effect (January 1987) in which to implement the accounting changes necessary for separate subaccount treatment.
Nowadays it would be surprising to find a retirement plan accounting system that isn’t capable of handling these subaccounts. The only apparent reason for failing to make this treatment available to participants who have made after-tax contributions would be a misunderstanding of the law. Nevertheless, the fact remains that employer plans are not legally obligated to provide this favorable treatment.
Designating the separate subaccount
It’s one thing to maintain a separate subaccount for after-tax contributions and their earnings, and another to designate a particular payment as coming from that subaccount. The IRS laid out rules for doing this in Notice 87-13, which says (Q/A 14) “a plan (or plan procedures) must either specify the contract from which distributions are to be made or permit participants to designate the contract from which a requested distribution is to be made.” Therefore:
- Rules for doing this do not have to be part of the plan document; they can simply be a procedure used in administering the plan.
- The plan can give participants the choice as to whether a particular distribution comes from the separate subaccount. Alternatively, the plan may simply treat all distributions as coming from the separate subaccount until it is exhausted.
The IRS may have inadvertently contributed to confusion regarding this rule in its Fall 2008 Retirement News for Employers (PDF). In a brief Q&A on page 8 they seem to say your after-tax contributions have to be recovered pro rata with the entire account balance. This is not the position of the IRS, however. The IRS explains the treatment of after-tax contributions and their earnings in Publication 575, Pension and Annuity Income (PDF) (see discussion on page 17, including example).
Comment: The employer newsletter represents informal, nonbinding guidance from the IRS. We understand that the IRS included this particular item to alert employers that they could not simply distribute the after-tax dollars alone (without any pre-tax dollars, including investment earnings). The failure to mention the separate subaccount rule (or the rule for pre-1987 after-tax contributions) was either an oversight or a choice made based on space limitations in the newsletter.
Employers can and should make separate subaccount treatment available for all non-annuity distributions to current or former employees from employer plans that permit after-tax contributions.
- Isolating Basis for a Roth Conversion
- Isolating IRA Basis
- Basis Recovery from Employer Plans
- Separate Subaccount Treatment
- Simple Payout
- Using an IRA to Isolate 401k Basis
- Split Rollover Methods
- Roth Retirement Accounts (top of this guide)
- Roth Conversions (top of this section)
- Go Roth! (our plain language guide to Roth accounts)