|Question 172: We maintain a savings plan with a 401(k) feature, post-1986 after-tax contributions, pre-1987 after-tax contributions and employer contributions. The 401(k) contributions are separately accounted for, the post-'86 after-tax contributions are separately accounted for, and the employer contributions AND pre-1987 after-tax contributions are separately accounted for. We allow partial withdrawals from the plan after termination of employment and we allow participants to select from which "pot" of separately accounted for money the distribution will be made. Thus, an employee can take a fully taxable withdrawal just from the 401(k) account by liquidating those investments. Is this the correct procedure, or is there some sort of default tax rule that should apply -- pre-'87 after-tax contributions should be deemed distributed first, then taxable 401(k) and employer money next, etc. I understand that post-'87 after-tax money can be treated separately, but what about the other plan monies which are each separately invested?
Answer: In effect, you are asking whether the plan can allow the participant to select which separate "program of interrelated contributions and benefits" (Treas. Regs. section 1.72-2(a)(3)) under the plan his partial distributions come from, thereby affecting what portion of the distribution is considered a tax-free return of basis.
Normally the plan document controls the ordering of distributions. When the plan document allows this, or the document is silent and the plan's procedures allow it, the IRS has approved the ability of a plan to allow the participant to designate which "program" his distribution comes from. See PLR 9652031.
This topic is discussed in Chapter 7(II) of The Retirement Plan Distribution Book.