On September 18, 2014, the IRS published IRS Notice 2014-54, Guidance on Allocation of After-Tax Amounts to Rollovers. The IRS explains in this notice how taxation applies when a retirement plan participant takes both pre-tax and after-tax funds (this is not referring to Roth 401k funds but rather after- tax contributions where the earning grow tax deferred) from a qualified plan (for example, a 401k plan, 403b or 457b).
The most important takeaway from Notice 2014-54 is the freedom for qualified plan participants with both pre-tax and after-tax money in their employer plans, like full-time employer 401k plans and solo 401k plans (a type of 401k but for the self-employed), 403b plans, and 457b plans maintained by a governmental employer, to transfer the pre-tax and after-tax funds to different retirement accounts.
While IRS Notice 2014-54 allows for the allocation of pre-tax and after-tax money to any type of retirement account, for those who are self-employed and can thus open a solo 401k plan, it might be most beneficial to transfer the pre-tax portion to the pre-tax solo 401k bucket (i.e., the pre-tax solo 401k bank account), while at the same time allocating the after-tax portion to an after-tax solo 401k bucket (i.e., after-tax solo 401k bank account). By proceeding in this fashion, solo 401k owners will be able to retain the tax-deferred status on the pre-tax amounts of their distributions and simultaneously convert only the after-tax portions of their qualified plan distributions, tax-free. Subsequently, the solo 401k owner may choose to process an in-plan Roth Solo 401k conversion of the after tax funds. Once the after-tax funds have been converted to the Roth Solo 401k, all the gains will grow tax free.
Alternatively, the qualified plan participant with both pre-tax and after-tax plan funds can directly rollover the after-tax funds to a Roth IRA and then direct rollover their pre-tax money to a traditional IRA, per IRS Notice 2014-54.
John has $200,000 in his traditional 401k and separates from his employer. The balance of his 401k is made up of $120,000 of pre-tax salary deferrals and earnings, and $80,000 of after-tax contributions. John is eligible to request a distribution of all or some of his former employer 401k plan.
Because of IRS Notice 2014-54, John now has the option to split up the 401k distribution as follows: 1) have the pre-tax amount directly rolled over into a Traditional IRA, or a pre-tax solo 401k plan if John is self-employed; an 2) have the after-tax funds directly rolled over (converted) to a Roth IRA, or an after tax solo 401k. John can then process an in-plan Roth Solo 401k conversion of the after-tax funds.
COMPLIANCE NOTE: Notice 2014-54 does not apply to IRA distributions. You cannot convert only nondeductible IRA contributions to a Roth IRA if you also have traditional IRA funds. This is because the pro-rata tax rules apply to IRA distributions.
Notice 2014-54 doesn’t change the way plan money is distributed. In other words, eligible distributions from plans are still subject to the pro-rata basis rules.
Ben has $75,000 in his Solo 401k plan that is all eligible for distribution. Ben’s balance is made up of $50,000 of pre-tax salary deferrals and $25,000 of after tax contributions. Benjamin decides to take a distribution of $25,000. He cannot distribute only his $25,000 of after-tax funds. Instead, the $25,000 solo 401k distribution will be made up of a proportionate amount of pre-tax and after-tax funds, as was the rule prior to Notice 2014-54. In sum, the notice does not affect the way pre-tax and after-tax money flow out of the plan.