New IRS Regulations Simplify Roth IRA Rollovers

  Spring 2017

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, it’s now easier and cheaper to transfer after-tax funds from designated Roth accounts to Roth IRAs or other designated Roth accounts. Many retirement savers will find this beneficial because of the increased flexibility when it comes to making Roth IRA rollovers.

How Are Roth Account Distributions Treated Now?

In general, qualified distributions from Roth IRA accounts are not taxable; however, with nonqualified distributions the general rule changes. When nonqualified distributions are made from designated Roth accounts, they’re considered to include a pro rata share of both after-tax and pretax funds, where 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 designed 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, though they also can be applied for distributions made between September 18, 2014, and 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.