Guest Article

(From the April 5, 2010 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Confusion Regarding Partial Rollovers of After-Tax Contributions

Following recent IRS pronouncements, benefits practitioners are concerned about the proper tax treatment of after-tax contributions where a participant elects a direct rollover of a portion of his or her qualified plan distribution.

Safe Harbor Notice Distinguishes Direct Rollover from 60-day Rollover

Recently, the IRS issued Notice 2009-68 which provides an updated "safe harbor" explanation for qualified plan administrators to use in satisfying the notice requirement under Code § 402(f). The standard safe-harbor notice, for distributions that are not from a designated Roth account, summarizes the rules that apply to after-tax contributions. Where the participant elects to roll over only part of his or her qualified plan distribution, the notice makes an important distinction between a direct rollover and a 60-day rollover. Essentially, it states that with a 60-day rollover the after-tax contributions are rolledover last, while with a direct rollover the after-tax contributions are allocated to both the rollover amount and the amount paid to the participant. As explained in the IRS's safe harbor notice:

(The safe harbor notice for designated Roth accounts contains similar language, stating that the direct rollover of only a portion of the Roth account will result in each of the portions being allocated their share of the after-tax contributions. This notice may be found on the IRS website at: www.irs.gov.)

Code Provisions Apply "Last Out" Rule

In contrast, Code § 402(c)(2) treats after-tax contributions, under either the direct rollover or the 60-day rollover approach, as being rolled over last to the recipient IRA or qualified plan. Code § 402(c)(2)(A) requires after-tax amounts that are rolled over to a qualified plan to be done via a direct trustee-to-trustee transfer, and requires the recipient plan to separately account for the after-tax amounts and their earnings. Code § 402(c)(2)(B) allows after-tax amounts to be rolled over to an individual retirement account or individual retirement annuity via either a direct rollover or a 60-day rollover, and does not require those IRAs to separately account. Code § 402(c)(2) then goes on to state:

Code § 402(c), therefore, applies the "last out" rule to after-tax contributions regardless of whether they are rolled over in a direct rollover or a 60-day rollover to the recipient qualified plan or IRA. This "last out" ordering is the one commonly used by qualified plan administrators in allocating after-tax contributions in the case of partial direct rollovers. However, based on the language of the notice, the IRS appears now to be saying that such ordering is incorrect. Rather, the IRS appears to be saying that the Code § 402(c) special "last out" rule does not apply where there is only a partial direct rollover. Outside of the Code § 402(c) special rule, after-tax contributions are generally allocated pro-rata to distributions. Code § 72(e) provides that, for purposes of determining the taxable portion of a partial distribution from a qualified plan where the benefit includes after-tax contributions, the after-tax contributions are allocated pro-rata to the partial distribution. It appears that the IRS is applying that "partial distribution" rule to partial rollovers under Code § 402(c).

Implications

Whether or not a direct rollover contains after-tax contributions, and the amount of those contributions, has immediate repercussions. The recipient qualified plan is required to separately account for rolledover after-tax contributions and their related earnings. Even though a qualified plan accepts rollovers, it does not always accept the rollover of after-tax amounts. Under the clarified rule, a plan that previously accepted a partial direct rollover may now realize it also accepted a pro-rata portion (or a greater prorata portion) of the participant's after tax contributions from the qualified plan. The clarified rule, therefore, raises the specter of operational qualification failures.

Although IRAs are not required to separately account for after-tax amounts, IRA owners are obligated to maintain proper accounting in order to avoid double taxation. Plan administrators are required to report the participant's distribution on two separate Forms 1099-R . one for the portion directly rolled over and one for the portion distributed to the participant . and to report with regard to each portion the amount of the employee after-tax contributions and the taxable amount. The clarified rule might ultimately require the issuance of corrected Forms 1099-R.

Whether the IRS will take steps to address the inconsistency between the general administrative practice and its newly clarified position is not certain. The IRS seems to have affirmed its newly clarified position in the recently released Spring 2010 Employee Plans News.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Deborah Walker 202.879.4955. Copyright 2010, Deloitte.