By Kaye A. Thomas
Current as of February 10, 2018
Under prior law, some people used split rollover techniques.
This page describes strategies for isolating basis that were helpful to some people under prior law. As a result of guidance issued by the IRS in September 2014, there is no longer a need to use these strategies. We retain this page only for reference by those who may have used these techniques in the past.
The cleanest technique for isolating basis in an employer plan is to roll the entire account to an IRA and then use the IRA basis isolation approach. You can’t use this approach unless you’re able to roll pre-tax dollars out of the IRA to an employer plan, however. To overcome that problem you may wish to consider a split rollover method. There are at least three variations, all of which have drawbacks. The first two seem unlikely to pass muster with the IRS. The third, while not ironclad, is more defensible, but requires the plan to withhold income tax on the pre-tax dollars, a problem that in some cases may make this approach impracticable.
In the direct split variation, you would request a distribution of your entire account, with the pre-tax dollars being paid directly to a traditional IRA and the after-tax dollars being paid directly to a Roth. The hope is that the IRS will respect this allocation of pre-tax and after-tax dollars, so that you have a tax-free rollover of the pre-tax dollars — with no income tax withholding, because it’s a trustee-to-trustee transfer — and a tax-free conversion of the after-tax dollars.
This treatment would arguably be available if you can be treated as taking a single distribution from your retirement account. The problem is that the IRS is likely to take the position that you’ve taken two distinct distributions: one that goes to the traditional IRA, and one that goes to the Roth. A proportionate division between pre-tax and after-tax dollars applies to each distribution, so the attempt to isolate basis fails.
We have no clear guidance from the IRS as to the treatment of this transaction. The law itself is unclear, because we don’t have anything that tells us whether this method should be treated as a single distribution that goes to two destinations or as two distinct distributions. My understanding is that the IRS is likely to take the latter (unfavorable) position, and in my judgment there is a good chance the IRS would prevail if that position were tested in court.
Distribution that is split by trustee
Some have suggested that a change in paperwork may overcome this problem. Instead of having the plan issue one check for the pre-tax dollars and another for the after-tax dollars, we would have the plan issue a single check for the entire amount to an IRA trustee that has been instructed to divide it appropriately between traditional and Roth accounts. The thought is that this transaction should be treated as a single distribution because the plan has issued a single check to a single recipient.
Experts may disagree on the strength of this argument. In my view the IRS still has a strong argument that the arrangement should be treated as two distinct distributions because the money is actually going to two different recipients, a traditional IRA and a Roth.
Distribution to owner rolled to two IRAs
The third variant requires three steps:
- Have the entire account distributed to you personally.
- After receiving this amount, make a rollover contribution to a traditional IRA in an amount equal to the pre-tax dollars.
- After making the rollover to the traditional IRA, make a rollover contribution to a Roth IRA in an amount equal to the after-tax dollars.
The third step has to be completed within 60 days after the distribution that was made in the first step, and it should be clearly documented that the second step occurred before the third step (i.e., don’t do the last two steps at the same time).
Legal analysis. This technique relies on two provisions in the tax law. The last sentence of section 402(c)(2) of the Internal Revenue Code says (in effect) that if you receive a distribution from a retirement plan that includes basis, and you make a partial rollover of that distribution to a traditional IRA, the rollover is treated as coming first from the pre-tax dollars. This means that if you roll an amount equal to the pre-tax dollars that were included in the distribution, the remainder of the distribution consists only of after-tax dollars. If you stopped after step 2 above, you would pay no tax on the distribution even though the distribution is a blend of pre-tax and after-tax dollars and you rolled only part of it to a traditional IRA.
Then we look to section 408A(d)(3)(A)(i), which tells us in effect that the amount of income you report on a rollover from a traditional account to a Roth IRA is equal to the amount you would report if you received this distribution without rolling it over. As we’ve seen, the amount that would be taxable in the absence of this rollover is zero.
Some experts believe the IRS could make the same argument against this variant of the split distribution technique as we noted earlier for the other two, saying it should be treated as two distributions. This argument, if successful, would prevent you from receiving the desired treatment. Although there can be no assurance, in my judgment the IRS is unlikely to take this position.
For one thing, this result is arguably within the intent of the law. Congress clearly understood that a partial rollover to a traditional IRA could be used to isolate basis for a tax-free distribution (if you stopped after step 2 above). Given the overall scheme of taxing Roth conversions the same as distributions, it seems plausible that you should be able to accomplish a tax-free Roth conversion in circumstances where you can receive a tax-free distribution.
What’s more, it isn’t clear that the IRS could sustain a challenge to this result. Step 1 is a distribution of the entire account to you, and upon receiving this distribution you’re free to do with it as you wish, rolling some of it, all, or none to a traditional or Roth IRA. The subsequent steps may be part of a plan but in my view are not closely enough integrated to cause the payout to be treated as two distinct distributions.
Withholding. Unfortunately, in overcoming (we hope) the problem of having two distinct distributions, we’ve created another problem. Employers are required to withhold 20% of the pre-tax dollars paid out of a qualified retirement plan unless the distribution is directly rolled to a retirement account (IRA or another employer plan). You would need to come up with replacement dollars to complete the rollover, and then recover the dollars that were withheld when you file your income tax return for the year of the distribution.
Example: Your 401k account has a value of $1,000,000, including $200,000 of after-tax contributions and $50,000 of earnings on your after-tax contributions. You request a distribution of $250,000 from the subaccount that holds your after-tax contributions and associated earnings. You receive a check for $240,000, because 20% of the taxable amount is withheld. You make a rollover contribution of $50,000 to a traditional IRA, leaving you with $190,000. To get the full benefit of this transaction, you need to come up with an additional $10,000 so you can make a rollover contribution of $200,000 to your Roth IRA. The $10,000 withholding will increase your refund or reduce your tax due when you file your income tax return for this year.
Chances are that a shortfall of $10,000 would be manageable one way or another. Larger amounts could make it impracticable to use this approach, however. Consider what would happen in the previous example if your employer does not make it possible for you to take a distribution from the separate subaccount for after-tax contributions and associated investment earnings. (Employers are permitted but not required to make this treatment available.) In this case, you would need to withdraw the entire $1,000,000 account, with $800,000 consisting of pre-tax dollars so that withholding would be $160,000. The need to come up with $160,000 from another source to complete your rollover may be an obstacle you can’t overcome.
- 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