Editor’s Note: This is an occasional feature in the NTSA Advisor. It is drawn from The Source, a book that covers technical, compliance, administrative and marketing aspects of the 403(b) and 457(b) markets. More information about The Source is available here.
The Unemployment Compensation Amendments Act of 1992 (UCA) contained a revenue raiser in the form of new rollover rules for qualified plans, including 403(b) plans. The rollover rules under UCA are also extended to the 457(b) eligible deferred compensation plans of governmental employers, but not to the 457(b) plans of tax-exempt employers. It is important to note that IRAs, including SEP IRAs and SIMPLE IRAs, are not included in these particular rollover rules.
The “revenue raiser” is a mandatory 20% federal income tax withholding requirement applicable to any distribution from a qualified plan (including 403(b) and governmental 457(b) plans) that is otherwise eligible to be rolled over, but is distributed directly to the participant. Thus, only 80% of the account value will be distributed to the participant if it is not directly rolled over. If a participant wants to rollover 100% of the amount distributed, a direct rollover is the best option.
Otherwise, the mandatory 20% withholding requirement requires the individual to make up the “missing” 20% from another source. If the withheld amount (20%) is not re-deposited by rollover into an eligible retirement plan, the 20% becomes a taxable distribution.
If the individual is under age 59½, it may also be subject to the 10% premature distribution penalty.
To avoid the 20% mandatory withholding, the rollover must be done through a direct rollover from one plan (or insurance company or mutual fund vendor) directly to another on behalf of the individual. Because a direct rollover is the only way to avoid the mandatory withholding, the regulations provide that notice of the direct rollover option must be provided. Each 403(b) annuity contract and custodial account held under a plan, as well as the 403(b) plan document and plan documents for qualified and governmental 457(b) plans must contain language providing for direct rollovers.
In order for the desired taxation to occur for taxpayers, rollovers of accounts containing both pre-tax and after-tax amounts had been limited only to indirect rollovers, thus, imposing the IRS 20% mandatory withholding on the distributed amounts, and interfering with the movement of death benefits to non-spouse beneficiaries, which can only be done directly. However, effective on Jan. 1, 2015, the IRS has changed the taxation rule in Notice 2014-54 (available at http://www.irs.gov/pub/irs-drop/n-14-54.pdf). Participants in 401(a)/(k), 403(b) and governmental 457(b) plans will be permitted to directly roll over accounts containing both pre-tax and after-tax money as long as they “designate” on the distribution request where the different sources of monies are being rolled to. In the past, via indirect rollover, participants could first indirectly rollover the pre-tax portion of the account; then, in a separate transaction, indirectly rollover the remaining post tax portion of the account to a separate destination (generally, to a Roth IRA). Now the rollover can be done directly, with the pre-tax portion, and the after-tax portion of the values allocated to separate destinations, with no taxation.
In 2016, the IRS made a similar change in the Roth regulations to permit the same ‘designation’ distribution for the taxation rules from the Roth portion of the 403(b), 401(k), or 457(b) plan.
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