In the Spring, 2010 edition of employee plans news, the Internal Revenue Service (the "IRS") provides guidance on rollovers to Roth IRAs. The guidance covers (1) what can and cannot be rolled over to a Roth IRA, (2) specific types of distributions that may not be rolled over (including required minimum distributions), (3) rollovers from inherited IRAs and (4) treatment of the taxable and nontaxable portion of the rollover. The interesting part of this guidance is the treatment of taxable/nontaxable amounts being rolled over. Here is what the IRS said on this treatment:
After-tax money that you roll over (convert) from an IRA (other than a Roth IRA) or a qualified retirement plan to a Roth IRA is not included in your gross income. However, when you roll over a distribution from a non-Roth IRA or a qualified retirement plan that contains after-tax and pre-tax amounts to a Roth IRA, you must determine the after-tax and pre-tax amounts in the distribution. You must generally report the pre-tax amount as gross income for the year in which it is distributed from the IRA or plan, even if you roll it over to a Roth IRA. The 10% early distribution tax under Code section 72(t) does not apply to any amount rolled over to a Roth IRA (although it may apply if amounts rolled into the Roth IRA are distributed within 5 years).
As to a rollover from an IRA, you must calculate the after-tax and pre-tax amounts of any IRA distribution that you roll over to a Roth IRA, even if the roll over is a direct (trustee-to-trustee) rollover. If any of your IRAs (not including Roth IRAs) contain non-deductible (after-tax) contributions, you have to combine all your non-Roth IRAs to pro-rate a distribution between pre-tax amounts (deductible contributions and earnings) and after-tax amounts. The formulas to determine these amounts are:
--after-tax amount = after-tax amounts in all IRAs at year-end, divided by the value of all IRAs at year-end, multiplied by amount distributed
--pre-tax amount = amount distributed - after-tax amount
In applying this formula: (1) this calculation is done at year-end (on December 31 of the year of the distribution) and not on the distribution date, (2) "IRAs" include any traditional, SEP and SIMPLE IRAs, but not Roth IRAs and (3) you do not include any IRAs that your spouse may have.
As to a rollover from a qualified retirement plan, if you roll over a distribution from a designated Roth account under the plan to a Roth IRA, you do not include any amount rolled over in your gross income. The law treats the rollover as being from one Roth IRA to another, except the 5-year period for determining qualified distributions from a designated Roth account does not carry over to the Roth IRA.
A special rule applies if you made after-tax contributions to a qualified retirement plan before 1987, the plan separately accounted for them and the plan permitted withdrawals from this account. You can request that your qualified retirement plan roll over these pre-1987 after-tax contributions, without earnings, to a Roth IRA. If the amount rolled over consists of after-tax contributions only, then you do not have to include any portion of the rollover in your gross income.
If you roll over a qualified retirement plan distribution that consists of both after-tax and pre-tax amounts, then use the following formula to determine the after-tax and pre-tax amounts:
after-tax amount = after-tax contributions in your plan account(s), divided by the value of your plan account(s), multiplied by amount distributed
pre-tax amount = amount distributed - after-tax amount
In applying this formula: (1) do not include any designated Roth contributions, (2) "value" is the total of your plan account(s) at the time of the distribution but does not include the value of any of the plan's designated Roth account(s) and (3) "amount distributed" is the amount distributed to you and rolled over (directly or otherwise) to a Roth IRA.
If you receive an IRA or qualified plan distribution that consists of after-tax and pre-tax amounts, you would first use the applicable formula above to determine the pre-tax amount of the distribution. If you roll over only part of that distribution to a Roth IRA, the first dollars rolled over come from the pre-tax amount of the distribution. After all the pre-tax portion of the distribution has been rolled over, any remaining amount is after-tax, which may also be rolled over to a Roth IRA.