The IRS recently published amended final regulations that will allow designated Roth account owners to tailor the tax results from their distributions. This gives owners of the accounts greater flexibility in personal tax planning. Here are the details, including an example of how the new guidance can lower taxes on distributions from designated Roth accounts.
Does your employer offer a 401(k), 403(b) or governmental 457 plan? If so, you may be able to set up a designated Roth account through your company’s plan. Then your Roth account will be allowed to receive designated Roth contributions that are taken out of your salary through so-called “salary-reduction contributions.” Here’s more on how this strategy works, why it may be advantageous for certain taxpayers and how new IRS regulations add greater flexibility to allocating distributed after- and pretax amounts.
Designated Roth Account Basics
Unlike regular salary-reduction contributions, designated Roth contributions don’t reduce your taxable salary. Instead, the tax advantage comes later when you are allowed to take distributions from your designated Roth account without owing any federal income tax. These tax-free amounts are referred to as qualified distributions.
The catches to receiving tax-free qualified distributions are twofold: First, the Roth account must have been open for more than five years. Second, you must have reached age 59½ or become disabled before taking distributions from your Roth account.
The five-year period is deemed to begin on the first day of the year in which you make your first designated Roth account contribution. For example, if you made your first contribution anytime in 2014, the five-year period is deemed to have started on January 1, 2014. In this scenario, you can receive tax-free qualified distributions anytime after December 31, 2018, as long as you’re at least 59½ or disabled. If you die, your heirs can receive tax-free qualified distributions as long as the five-year requirement has been met.
Important note: Setting up a Roth account makes the most sense if you believe you’ll pay the same or higher tax rates during your retirement years.
Treatment of Designated Roth Account Distributions
At some point, you may want to direct designated Roth account distributions to multiple destinations — say, to one or more taxable accounts and one or more tax-favored accounts — using tax-free rollovers. These transactions can be executed using the 60-day rollover rule or via direct rollovers where money is transferred directly between accounts. Favorable IRS rules generally allow you to allocate after-tax (tax-free) amounts from nondeductible contributions and pretax (taxable) amounts from deductible contributions and account earnings to the various destinations to achieve the best tax results.
The IRS recently issued an amended final regulation to eliminate a previous requirement affecting some Roth account transactions. That requirement mandated that a disbursement from a designated Roth account that was directly rolled over into a Roth IRA or another designated Roth account be treated as a separate distribution from any amount simultaneously paid directly to the account owner (you). When such mandatory separate distribution treatment applied, the pretax and after-tax amounts included in the designated Roth account disbursement had to be allocated pro rata to each separate distribution.
The following example illustrates how the now-eliminated rule that required distributions from designated Roth accounts to be treated separately could lead to unfavorable tax results.
Example 1: Old rule for designated Roth account distributions. A 50-year-old woman owns a Roth IRA. She also has a $50,000 balance in a designated Roth account set up through her employer’s 401(k) plan. The designated Roth account balance consists of $30,000 of after-tax dollars (from nondeductible contributions to the account) and $20,000 of pretax dollars (from account earnings). Therefore, 60% of the account balance ($30,000/$50,000) is after-tax money and 40% ($20,000/$50,000) is pretax money.
The woman quits her job and arranges for a $50,000 disbursement to close out the designated Roth account. This is not a qualified designated Roth account distribution, because she’s not age 59½, disabled or dead. So, if she puts the entire $50,000 into a taxable account with a bank or brokerage firm (or straight into her pocket), the woman will owe federal income tax on the $20,000. She’ll probably owe the dreaded 10% early distribution penalty on the $20,000 and any applicable state income taxes, too.
What if, instead, she chose to put $30,000 of the $50,000 into a taxable account (or her pocket) and rolled over the remaining $20,000 into a Roth IRA using a direct transfer? Under the old separate distribution rule, the woman was required to treat the $30,000 that she didn’t roll over as consisting of $18,000 of after-tax money (60%) and $12,000 of pretax money (40%). Similarly, the $20,000 that she directly rolled over into her Roth IRA was deemed to consist of $12,000 of after-tax money (60%) and $8,000 of pretax money (40%).
As you can see, the unfavorable separate distribution rule would have resulted in the woman owing taxes on the $12,000 of pretax money that’s deemed to have gone into her taxable account (or pocket). She also might have owed the 10% penalty tax and state income tax on the $12,000.
New IRS Guidance on Designated Roth Account Distributions
Fortunately, under a recently amended IRS regulation, separate distribution treatment is no longer required when part of a disbursement from a designated Roth account is directly rolled over tax-free into one or more eligible retirement accounts and part is sent to the account owner.
Now, you can follow the taxpayer-friendly rules to allocate after-tax and pretax amounts between the destinations to achieve the best tax results. The following example illustrates how the new guidance adds greater flexibility to allocating distributed after- and pretax amounts.
Example 2: New, more flexible rule for designated Roth distributions. Now that the separate distribution rule no longer applies, the woman in the previous example has a more tax-favorable option for allocating her distributions. Pursuant to IRS Notice 2014-54, she can treat the $30,000 that was transferred into the taxable account (or her pocket) as consisting entirely of after-tax (tax-free) dollars, and she can treat the $20,000 that was directly rolled over into her Roth IRA as consisting entirely of pretax dollars.
Under the new guidance, she would owe no federal income tax on the designated Roth account disbursement and no 10% early-distribution penalty or state income taxes. In addition, she’ll be eligible to take the $20,000 out of her Roth IRA through tax-free qualified Roth distributions once she reaches age 59½ (or becomes disabled).
Effective Date
The amended final regulation applies to distributions from designated Roth accounts that are made on or after January 1, 2016. However, you can also elect to follow the favorable amended final regulation for distributions that were made on or after September 18, 2014, and before January 1, 2016. For more information about how the new guidance applies to your Roth accounts, contact your a WFY tax advisor here.
Copyright 2016