Consolidating retirement assets is sometimes a good idea, especially if you want to reduce administrative and trade-related fees that are charged to each of your retirement accounts. However, if your retirement-plan account includes after-tax assets and you want to combine the assets with those of an IRA, you should be aware of how your IRA is affected when after-tax assets are rolled into it. In this article, we review the accounting requirements and tax treatment of after-tax amounts that are rolled to a Traditional IRA from a qualified plan or 403(b) account.
Before the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), after-tax assets could not be rolled over between qualified plans or 403(b) accounts and IRAs. Under EGTRRA, after-tax assets can now be rolled over from qualified plans and 403(b) accounts to Traditional IRAs (note that after-tax assets still cannot be rolled from IRAs to qualified plans). Of course, to roll over the assets, you must still satisfy your plan's requirements for distributions.
While many see this change as a good thing, it has created confusion and frustration for the individuals who unwittingly roll over their after-tax assets to their IRA without understanding the follow-up accounting and tax-filing requirements and the tax treatment of subsequent distributions from Traditional IRAs.
Should you rollover after-tax assets to your Traditional IRA, you are required to account for the after-tax assets and the pre-tax assets separately. This accounting is accomplished by filing IRS Form 8606 (available at the IRS website) for the year the after-tax amount is rolled over to the IRA, and for each year you distribute assets from any of your Traditional, SEP or SIMPLE IRAs.
This rule requiring the filing of Form 8606 applies even if the rollover is made from one of your Traditional IRAs that does not include after-tax assets: all of your Traditional, SEP and SIMPLE IRAs are treated as one IRA for the purpose of calculating the taxable portion of your distribution. The information provided on Form 8606 helps both you and the IRS determine the balance of your IRAs that is attributable to after-tax assets. This information also helps to ensure that you do not pay taxes on distributions that should be tax free.
Treatment of Distributions Subsequent to Rollover of After-Tax Assets
If after the rollover of after-tax assets you want to make distributions or Roth IRA conversions from your Traditional IRA, you cannot choose to take the assets from strictly either pre-tax or after-tax assets. Instead, until all the after-tax assets have been fully distributed, all distributions and/or Roth IRA conversions will include a pro-rated amount of pre-tax and after-tax assets. The instructions for filing Form 8606 explain the steps for determining the taxable and nontaxable portions of the distribution and/or Roth conversion amount.
Rollover Is Irrevocable
After realizing the administrative requirements and distribution treatments that apply to rolled-over after-tax assets, some individuals want to reverse the transaction and instead have the after-tax amount credited to a non-retirement account. However, even if the individual claims ignorance or error and asks the IRA custodian to adjust or reverse the rollover to the IRA, the custodian is unable to make any such adjustments because once a rollover contribution is made to an IRA, it is irrevocable.
Ask for Separate Checks
In most cases, retirement-account owners realize the results of the rollover transaction only after the amount has been credited to the IRA. If you want to move your assets from your plan with your employer and you are unsure of whether the plan balance includes after-tax amounts, ask your employer or plan administrator. If it does and you do not want to rollover the after-tax amount to your Traditional IRA, ask for two separate checks: one for the after-tax amount and another for the pre-tax amount. The amount representing the after-tax assets can be deposited to your regular bank account. Bear in mind that the payor may be required to withhold 20% for federal taxes from amounts that are rollover eligible but are not being directly rolled over to an IRA or other eligible retirement plan.
Is Rolling Over After-Tax Assets Disadvantageous?
Rolling over assets can be advantageous for you; in fact it is comparable to you making nondeductible contributions to your IRA, where earnings accumulate on a tax-deferred basis.
Typically, the effects are negative when the IRA owner didn't realize that the rollover election included instructions to roll over the after-tax amount. The rollover may be negative also when the owner was unaware of the accounting requirements and tax treatment of the assets after the rollover.
If the IRA owner is content with keeping the after-tax amount in the IRA, then all is well. However, it can be a frustrating experience for those who prefer to use their after-tax balance without having to include any of the amount used as income: rolling the amount to their IRA means that any subsequent withdrawal must include a portion of their pre-tax balance.
The Bottom Line
When requesting transactions for your retirement account, be sure to read the fine print before you sign any instructions. If necessary, have your tax professional or legal representative review the documentation to ensure you understand how the transaction will affect you and your retirement account. When in doubt, ask as many questions as are necessary for you to feel comfortable. Your transactions should be something you knowingly enter into and are satisfied with, not something you have to live with because you were not fully aware of the rules.