Rolling over a non-qualified vs. qualified distribution from a designated ROTH account to a ROTH IRA

[David Peckham]

Client executed an in-plan conversion of employer PS account to a designated ROTH account on December 30, 2014. QDRO now authorizes 1/2 of that designated ROTH account to go to ex-spouse. Ex-spouse has never owned a ROTH IRA. Ex-spouse now elects a direct rollover from the plan to a newly-established ROTH IRA. Client and ex-spouse are both age 70, so the 10% penalty is not a concern. The only concern is whether all earnings (and the earnings are substantial since 2014) are tax-free or not.

Question #1: How does the 5-year holding period apply to ROTH IRA assets that originate from a transfer that would have been non-qualified if it had not been a direct rollover from the plan to the ROTH IRA?

Question #2: Suppose that the direct rollover does not occur until January 2, 2019. How does the 5-year holding period apply to ROTH IRA assets that originate from a transfer that would have been qualified if it had not been a direct rollover from the plan to the ROTH IRA?

 

[Luke Bailey]

I think:

1) The 5-year holding period for the Roth IRA begins with the first day of the calendar year in which the rollover amount is deposited into the Roth IRA, e.g., if this year, 1/1/2018. There is no tacking for the portion of the 5-year period already satisfied in the qualified plan.

2) Same answer.

You did not ask about the taxation of any distributions from the Roth IRA that occur before the 5-year qualification period is up, but I will offer the following:

* In case #1, the taxpayer's basis in the designated Roth account (i.e., the original 2014 conversion amount, but not any subsequent earnings in the qualified plan after 2014) is nontaxable basis in the Roth IRA following the rollover, but the portion of any distribution allocable to the non-basis amount (i.e., any earnings amount above the 2014 original conversion amount) is taxable until the five years has run for the Roth IRA.

* In case #2, the entire amount rolled over, i.e. the 2014 conversion amount and all earnings up to the date of the rollover in 2018 is basis. Earnings on that amount within the Roth IRA (i.e., the post-Roth IRA rollover earnings) are taxable when distributed until the new 5-year period for the rollover Roth IRA has run.

[David Peckham]

Thank you, Luke. I agree with your analysis. It doesn't seem fair, but the two 5-year holding periods are computed separately (designated ROTH account inside PS plan holding period vs. ROTH IRA holding period).

[K2retire]

11 hours ago, David Peckham said:

Thank you, Luke. I agree with your analysis. It doesn't seem fair, but the two 5-year holding periods are computed separately (designated ROTH account inside PS plan holding period vs. ROTH IRA holding period).

When have IRS rules ever had anything to do with the concept of fairness? 

[QDROphile]

You can argue fair all you want.  The rule has a lot of logic.  One looks at the vehicle that holds the funds to determine status.  Record keeping is thus simplified. Record keeping for carryovers is a lot more work.  “Unfair” can be counterbalanced by well-informed planning. Open a token Roth IRA when contributions to the Roth 401(k) account start.  Then the rollover has the benefit of parallel aging.  Not everyone can open a Roth IRA, but I shed no tears for the disqualified wealthy.  And hindsight is 20/20.

[Luke Bailey]

The most interesting aspect of this is that anyone who at any time is entitled to a distribution from a qualified plan (e.g., the millennial job changer who gets a separation from service distribution, the pre-retiree who can get an in-service distribution at age 59-1/2) and who understands the issue can avoid the problem by, as stated above, doing a token IRA rollover. Once the 5-year period on that IRA runs, everything stuffed into it later by way of further Roth rollovers is qualified money, whether or not (let alone how long) it was Roth in the qualified plan.