Distributions of After-Tax Assets from 401(k) Plans
Introduction
Much controversy has arisen around the apportioning and reporting of distributions
and conversions of after-tax contributions from defined contribution plans. This
paper analyzes the topic based on guidance provided by the following tax laws and
IRS pronouncements:
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Notice 87-13 (Basis recovery rules)
IRS Publication 575 (Examples of basis recovery rules)
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)
Job Creation and Workers Assistance Act of 2002
The Tax Increase Prevention and Rec onciliation Act of 2005 (TIPRA)
Pension Protection Act 2006
Notice 2008-30 (Rollovers from QPs to Roth IRA)
Notice 2009-68 (Safe harbor IRC Sec. 402(f) rollover notices)
Notice 2009-75 (Income tax consequences of rollover from QP to Roth IRA)
2012 IRS Form 1099-R Instructions
Executive Summary
If the plan document so permits, it may be possible for a participant to request a
distribution of his or her 401(k) plan after-tax account (or contract)1 while still
working.2 Since 1987, as a result of the Tax Reform Act of 1986 (TRA-86), plans
have been allowed to treat employee after-tax contributions and associated earnings
as made to a separate account (or contract) under the plan that is segregated from
the remaining portion of the plan (IRS Notice 1987-13). If the plan had tracked the
participant’s pre-1987 after-tax employee contributions and earnings thereon, the
plan may treat the separate account as comprised of all employee after-tax
contributions and earnings thereon (i.e., pre-1987 plus post-1986 employee
contributions and earnings).
TRA-86 also introduced new basis recover rules applicable to the distribution of post1986 contributions and earnings from employee after-tax accounts. A special
1
When referring to employee after-tax accounts, IRS pronouncements still use
somewhat archaic language, which dates back to the day when plans were often in
the form of annuity contracts. For example, in IRS Publication 575, the language
regarding after-tax contributions refers to maintaining them in a separate “contract”
as opposed to separate account as would be the common nomenclature today.
2
Plans may distribute after-tax accounts based on distribution triggering events
written into plan documents. Separation of service is a common distribution trigger.
But it is not unusual, though not always the case, for a plan sponsor to elect a
provision in the governing plan document that permits in-service/nonhardship
distributions of after-tax account assets at any time (regardless of the participant’s
age or time of participation in the plan).
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grandfather rule excludes pre-1987 employee after-tax contributions from the basis
recovery rules (IRS Notice 1987-13, Q&A 13). Therefore, the tax consequences of a
distribution from an employee’s separate after-tax account will depend on whether
the distribution comes from the pre-1987 employee after-tax contributions or post1986 employee after-tax contributions and earnings. Pre-1987 after-tax
contributions potentially can be recovered without associated earnings. Post -1986
after-tax contributions and earnings in the account are subject to the basis recovery
rules that require the participant to treat recovered amounts as consisting of a pro
rata share of after-tax contributions and earnings. If a distribution consists of post 1986 employee after-tax contributions and earnings, only a portion will be
excludable from taxable income as a return of basis—that is the employee’s after-tax
contributions. The portion of the distribution that is excludable is based on the same
ratio as the ratio that reflects the participant’s after-tax employee contributions to
the participant’s total vested after-tax account balance.
Prior to 2002, the portion of a distribution that represented a return of employee
after-tax contributions was not eligible for rollover. The Economic Growth and Tax
Relief Reconciliation Act of 2001 (EGTRRA), changed that rule. Effective January 1,
2002, employee after-tax contributions may be included in an eligible rollover
distribution, provided the receiving plan is an IRA or a defined contribution plan that
separately accounts for after-tax amounts. Technical corrections to EGTRRA
contained in the Job Creation and Workers Assistance Act of 2002 clarified that if a
distribution to a participant includes both pre-tax and after-tax amounts, the portion
that the participant rolls over is treated as consisting first of pre-tax amounts.
Plan participants should consider two other law changes that affected distributions
and rollovers or conversions from after-tax accounts in qualified plans: the Pension
Protection Act of 2006 (PPA) and t he Tax Increase Prevention and Reconciliation Act
of 2005 (TIPRA).
PPA
Among the many provisions in this law is the ability of a participant to directly
rollover (convert) qualified retirement plan assets, including after-tax amounts
(presuming a distribution triggering event), to a Roth IRA without the intermediate
step of rolling to a traditional IRA first as was initially required. This change took
effect in 2008, resulting in plan participants having three qualified retirement plan
rollover options (plan permitting): 1) rollover to a traditional IRA; 2) rollover
(conversion) to a Roth IRA; or 3) rollover to another eligible employer-sponsored
plan. Although a conversion is a type of rollover, it is a potentially taxable event as
the individual must include any converted pre-tax assets in his or her ordinary
taxable income for the year, pursuant to general Roth conversion rules.
TIPRA
This tax law had a provision that eliminated the income restrictions on conversions of
traditional IRA and qualified plan assets to Roth-type accounts. There are now two
possible ways that plan participants could convert plan assets to Roth-type accounts.
One is through a rollover to a Roth IRA and the other is through an in-plan
conversion to a Designated Roth contribution account within a 401(k) plan. This was
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permitted through the Small Business Jobs Act of 2010. Although income limits
remain in effect on contributions to a Roth IRA, there are no income limits on
conversions to a Roth IRA. Note: There are no income limits on contributions to a
Designated Roth contribution account within 401(k), 403(b) or 457 plans. Nor are
there any income limits on “in-plan” conversions to those Roth accounts. The plan
must meet a few conditions to permit in-plan conversions: 1) offer a Designated
Roth c ontribution option and 2) include a distribution trigger to allow an in-plan
conversion.
Section II. Technical Summary
The following examples reflect application of the after-tax account basis recovery
rules pursuant to IRS Notice 87-13 and Publication 575.
= separate contract or account
$ 4,000
After-tax contributions
$ 2,400
Earnings on after-tax contributions
$ 9,600
Employer contributions and earnings (within a profit sharing account)
$16,000
Total
Assumptions
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In-service distribution triggering event
$3,000 distribution
Because the plan maintains a separate account for the after-tax contributions and
their earnings, the distribution will represent a pro rata return of after-tax and pretax amounts (earnings) based on the separate account only. In this case, the 9,600
in the profit sharing account, which consists of employer made contributions and
earnings, is not a consideration.
After-tax contributions
Formula:
Amount of distribution X
= Nontaxable portion
Value of separate account
$4,000
$3,000 X
= $1,875 tax free ($1,125 taxable earnings)
$6,400
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In other words, although an after-tax account within the defined contribution plan
and is combined with other contribution types for certain purposes (e.g., the IRS
Sec. 415 limit on overall contributions that a participant may receive annually), it is
a separate account (or contract) for distribution purposes. The record keeper is
required to track contributions and earnings separately. So long as the record
keeper does this, and any credible record keeper does, distributions from the aftertax account are distinct, and basis recovery is determined solely on what is in the
after-tax account and precludes consideration of what may be in other pretax and/or
designated Roth accounts in the plan.
Note: Although included in the IRC. Sec. 415 limits on annual contributions, which
for 2012 is $50,000 for someone under age 50 and $55,500 for someone age 50 and
above making catch-up contributions), after-tax accounts are not included in the IRC
Sec. 402(g) limit on salary deferrals and designated Roth contributions, which for
2012 is a maximum of $17,000 for someone under age 50 and is $22,500 for
someone age 50 and above. Therefore, based on what the plan permits, it is possible
for a participant to contribute from his or her salary over the IRC Sec. 402(g)
maximum limit if there is an after-tax account in the plan, subject to
nondiscrimination limitations.
Example 2
$ 2,000
Pre-1987 after-tax contributions independently tracked
$ 2,000
Post-1986 after-tax contributions
$ 2,400
Earnings on pre-1987 and post-1986 after-tax contributions
$ 9,600
Employer contributions and earnings (Profit sharing plan)
$16,000
Total
Assumptions
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Distribution trigger
$3,000 distribution
Pursuant to the grandfather provision of the basis recovery rules of Notice 87-13, the
first $2,000 is a return of the pre-1987 after-tax contributions tax free.
The taxability of the remaining $1,000 of the distribution is determined using the
formula.
$2,000
$1,000 X
= $454.55 tax free
$4,400
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$2,000 Pre-1987 + [$1,000 x ($2,000/$4,400)] = $454.55 tax free
Of the distribution, $2,454.55 is tax free and $545.45 is taxable since the pre-1987
$2,000 is tax free and a percentage of the $1,000 withdrawn from the remaining
$4,400 in the account is tax free.
Note: Ideally, a record keeper that is fulfilling a distribution request would cut
checks based on the participant’s intent. For example, if the participant wanted to
roll amounts over to IRAs but was determined to have a tax-free Roth conversion,
the record keeper would cut two checks: One for the $2,000 that is the pre-1987
contributions ($2,000), which would be a tax-free conversion of $2,000 dollars
because there are no pretax dollars undergoing conversion; and t he other check
would be for $1,000 and would consist of the pro rata amount of post -1986
contributions and earnings (subject to basis recovery rules). That check would be
made out to the traditional IRA and would consist of $454.55 in post -1986 after-tax
contributions and $545.45 in earnings.
But without explicit instructions from the participant, it is possible that the record
keeper would cut two checks but quite differently. If not instructed otherwise, t he
record keeper may cut one check that combines all the after-tax amounts (i.e., the
pre-1987 contributions of $2,000 and the post -1986 contribution amount of $454.55
for a total of $2,454.55); and a separate check with just the pre-tax amounts (in this
example, $545.45). The reason being, prior to 2002, this is how record keepers were
required to process distributions that included after-tax amounts due to the
prohibition of after-tax rollovers. It is possible that some record keepers have not
adjusted their systems to reflect 1) the ability to rollover after-tax amounts and 2)
the pro rata, basis recovery requirements that apply to post -1986 after-tax
contributions and earnings. Therefore, it is prudent for a participant to give very
explicit instructions on how distribution checks should be cut. Remember that in a
conversion situation, a plan participant must report the conversion to the IRS on
Form 8606 and Form 1040, and include what portion of the conversion is subject to
treatment as ordinary taxable income.
Example 3
$ 2,000
Pre-1987 after-tax contributions
$ 1,000
Post-1986 after-tax contributions
$ 1,000
Earnings on pre-1987 and post-1986 after-tax contributions
$14,000
All other amounts, which are all pre-tax
$18,000
Total
Assumptions
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Distribution trigger applies
$5,000 distribution
$2,000 Pre-1987 after-tax contributions removed tax free
$2,000 subject to basis recovery rules, calculated as follows
$2,000 x ($1,000/$2,000) = $1,000 tax-free withdrawal of post-1987 contributions
and $1,000 of taxable earnings
$1,000 taxable withdrawal from remaining pre-tax balance
Once again, the participant’s intent should be the key focus for how the record
keeper processes the distribution. Does the participant want to roll over the entire
distribution? If so, does he or she want it all to go to a traditional IRA or all to a Roth
IRA, or to divide it in some proportion between a traditional and Roth IRA?
Scenario 1
Sam is retiring from Smart Solutions, LLC. His 401(k) plan account statement reads
as follows.
Pre-1987 after-tax contributions
$20,000
Post-1987 after-tax contributions
$30,000 (of which $5,000 is earnings)
Employer Matching
$50,000
Profit Sharing
$50,000
Salary Deferrals
$50,000
Total
$200,000
Distribution options Sam is considering:
A: 100% direct rollover to a traditional IRA (or Roth IRA)
B: 100% distribution to Sam
C: A direct rollover of a portion to a traditional IRA (or Roth IRA) and a portion
distributed to Sam
D: A direct rollover of a portion to a traditional IRA and a converison of a portion to a
Roth IRA
How would the record keeper report each distribution option on IRS Form 1099-R?
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Option A 100% direct rollover to a traditional IRA (or Roth IRA)
Box 1—total amount rolled over = $200,000
Box 2a—taxable amount = If rolled over to a traditional IRA = “0;” if rolled over to a
Roth IRA $155,000 (i.e., $200,000-$45,000)
Box 5—Employee after-tax contributions = $45,000
Box 7—Distribution code = G for a direct rollover
Option B 100% distributed to Sam
Box 1—total amount distributed = $200,000
Box 2a—taxable amount = $155,000
Box 5—Employee after-tax contributions = $45,000
Box 4—Withholding = $31,000 ($155,000 x .20)
Box 7—Distribution code = 1 or 7 depending on Sam’s age
Option C: Direct rollover of a portion to a traditional IRA (or Roth IRA) and a portion
distributed to Sam
Sam instructs the plan administrator to directly roll over $155,000 to a traditional
IRA and distribute $45,000 to him (mistakenly thinking that this would be a totally
tax-free transaction).
The record keeper will complete two Forms 1099-R.
Form 1099-R #1
Box 1—total amount rolled over = $155,000
Box 2a—taxable amount = if rolled to a traditional IRA “0,” if rolled to a Roth IRA
“$116,250” (i.e., $155,000 - $20,000 of pre-1987 after-tax = $135,000;
$135,000 x $25,000/$180,000 = $18,750 nontaxable
$135,000 - $18,750 = $116,250 taxable
Box 5—Employee after-tax contributions = $38,750 ($20,000 Pre-1987 + $18,750,
which is .75 (i.e., $135,000/$180,000) of $25,000 Post -1986)
Box 7—Distribution code = G
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Form 1099-R #2
Box 1—total amount distributed = $45,000
Box 2a—taxable amount = $38,750
Box 5—Employee contributions = $6,250 ($25,000 x .25 (i.e., $45,000/$180,000) of
Post-1986)
Box 4—Withholding = $7,750 (i.e., $38,750 x .20)
Box 7—Distribution code = 1 or 7 depending on age
Questions: Does the participant c hoose which distribution has the $20,000 pre1987? Or—does he or she split it 50/50 between the two distributions?
Option D: Direct rollover to traditional IRA and conversion to a Roth IRA
Note: Currently, there is no IRS reporting guidance on how to handle this scenario
specifically. The 2012 instructions to Form 1099-R address the reporting of
combinations of one direct rollover and one distribution, and multiple distributions
with different distribution codes, but not two direct rollovers to different accounts.
Generally, the instructions state to aggregate distributions with like codes (e.g., “G”)
on one Form 1099-R.
One Form 1099-R (because distribution code “G” is the same for both amounts)
Conflict on Box 2a—taxable amount
are converted as taxable income.
Form 1099-R should include pre-tax assets that
Scenario #2
Sue, who also works for Smart Solutions, LLC, wants to take an in-service
distribution of her after-tax dollars because she learned the plan allows for it. Her
401(k) plan account statement reads as follows.
Pre-1987 after-tax
$20,000
Post-1987 after-tax
$30,000 ($5,000 earnings)
Employer Matching
$50,000
Profit Sharing
$50,000
Salary Deferrals
$50,000
$200,000
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The total amount in her after-tax account is $50,000. Sue requests a $50,000
distribution.
Distribution options Sue is considering:
A: 100% Direct rollover to a traditional IRA (or Roth IRA)
B: 100% Distribution to Sue
C: Direct rollover of a portion to a traditional IRA (or Roth IRA) and a portion
distributed to Sue
D: Direct rollover to a traditional IRA and direct rollover to a Roth IRA
Form 1099-R Reporting
Option A: $50,000 direct rollover to a traditional IRA (or Roth IRA)
Box 1—total amount rolled over = $50,000
Box 2a—taxable amount = If rolled to a traditional IRA, then “0;” if rolled to a Roth
IRA, then $5,000 (i.e., $20,000 pre-1987 after-tax, $25,000 post-1986 after-tax and
$5,000 earnings)
Box 5—Employee Contributions = $45,000
Box 7—Distribution code = G
Option B $50,000 Distribution to Sue Reporting
Box 1—total amount distributed = $50,000
Box 2a—taxable amount = $5,000
Box 5—Employee contributions = $45,000
Box 4—Withholding = $1,000 (i.e., $5,000 x .20)
Box 7—Distribution code = 1 or 7 depending on Sue’s age
Option C: $45,000 direct rollover to a traditional IRA (or Roth IRA) and $5,000
distribution to Sue
Two Forms 1099-R
Form 1099-R #1
Box 1—total amount rolled over = $45,000
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Box 2a—taxable amount = if rolled to a traditional IRA “0,” if rolled to a Roth IRA
“$4,166.67” (i.e., $20,000 pre-1987 tax free, $25,000 x ($25,000/$30,000) =
$20,833.33 nontaxable and $4,166.67 taxable)
Box 5—Employee Contributions = $40,833.33 ($20,000 + $20,833.33)
Box 7—Distribution code = G
Form 1099-R #2
Box 1—total amount distributed = $5,000
Box 2a—taxable amount = $833.33 (i.e., $5,000 x $25,000/$30,000 = $4,166.67
nontaxable)
Box 5—Employee contributions = $4,166.67
Box 4—Withholding = $166.67 ($833.33 x .20)
Box 7—Distribution code = 1 or 7 depending on Sue’s age
Option D: Direct rollover to a traditional IRA and direct rollover to a Roth IRA
Note: Currently, there is no IRS reporting guidance on how to handle this scenario
specifically. The 2012 instructions to Form 1099-R address the reporting of
combinations of one direct rollover and one distribution, and multiple distributions
with different distribution codes, but not two direct rollovers to different accounts.
Generally, the instructions state to aggregate distributions with like codes (e.g., “G”)
on one Form 1099-R.
1 Form 1099-R (because distribution code “G” is the same for both amounts)
Conflict on Box 2a—taxable amount Because the conversion of pre-tax assets is a
taxable event, an amount should be entered in Box 2a.
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Conclusion
The existence of an after-tax account in a defined contribution plan can lead to a taxefficient distribution or Roth conversion. Conservatively, only a distribution or
conversion of pre-1987 employee after-tax amounts may truly be a tax-free
transaction. Post-1986 employee after-tax contributions and earnings must be
distributed or converted by applying the basis recovery rules of Notice 87-13 and
Publication 575, resulting in a taxable transaction.
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