Do You Know When the Pro-Rata Rule Applies? This Week’s Q&A Mailbag
This week's Slott Report Mailbag looks into direct rollovers, Notice 2014-54, the pro-rata rule and NUAs. As always, we recommend you work with a competent, educated financial advisor to keep your retirement nest egg safe and secure. You can find one in your area here.
I have attended some of Ed’s seminars in the past and have a specific client question that I was hoping you can help me with.
In 2012, I did a direct rollover of a client’s 401k plan, which included before-and-after-tax funds, into a single IRA. The plan administrator would not allow us to split the funds.
I executed a direct IRA to IRA transfer of only the after-tax amount to another provider to keep those funds segregated from the before-tax funds.
In 2015 after Notice 2014-54 came out, I requested that only the initial after-tax funds, and no earnings on those funds, be internally transferred from the IRA to a newly established Roth IRA at the same provider.
Would this be considered a non-taxable conversion of after-tax 401k funds using Notice 2014-54, or do the funds have to come directly from a 401k and not an IRA?
Thank you for your assistance.
Unfortunately, your client’s 2015 conversion is subject to the pro-rata rule. This is because the funds were originally in a 401(k), and were rolled over to an IRA. It was the IRA that was converted to a Roth IRA. When funds are converted from an IRA, the pro-rata rule applies.
Keeping the after-tax dollars in a separate IRA does not change this. Under the pro-rata formula, the year-end balance of all of the client’s IRAs is divided into the total balance of all after-tax amounts in all of their IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the conversion. The remaining part of the conversion is taxable. The client cannot convert only the after-tax funds in their IRAs.
What about Notice 2014-54? Notice 2014-54 provides favorable guidance for people with after-tax money in their company retirement plan, such as a 401(k). The Notice allows individuals with both pre and after-tax money in a company plan, to convert just the after-tax money to a Roth IRA. These rules do not apply to IRAs. This is true even if the IRAs include after-tax dollars that may have been rolled over from a company plan.
I wanted to clarify if IRS rules for utilizing NUA was changed in 2017.
I retired from my company in 2011 and have not taken any distributions from my 401k. I have been planning to utilize NUA for my company's stock. It was my understanding I could do this any year as long as I did a complete distribution of the 401k in the same year.
I recently was told that you now have to take the distribution within one year after leaving your employer. Is that correct? I am 66, and again, I retired in 2011.
You can breathe easily. The rules for Net Unrealized Appreciation (NUA) have not changed. You are right in that the rules require a lump sum distribution. This means that all the funds in the plan must be distributed in one tax year. That year could be any year after you retire. There is no requirement that the lump sum distribution be taken within one year of the year of your retirement.
You can wait to use the NUA option in any year you choose. Just be careful. A partial distribution from the plan in any year could result in the loss of this valuable tax break.
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