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George F. Bearup, J.D. Senior Legal Trust Advisor

28-Oct-20

The ‘Cream in the Coffee’ Distribution Rule

Take-Away: A distribution from a retirement account is deemed to carry out proportionate amounts of the pre- and after-tax contributions in all of the participant’s accounts in the qualified plan, or all of the owner’s traditional IRAs. Calculating that proportion of the distribution that is not taxable can make your head spin when all of the IRA owner’s IRAs come into play. This pro rata rule may surface as individuals impacted by COVID-19 plan to take advantage of the CARES Act rule which permits up to a $100,000 distribution from a qualified plan or IRA in 2020 without incurring the 10% penalty for the early distribution before age 59 ½ from a retirement account.

Background: Distributions from qualified plans are taxable. [IRC 402(a).] The same for distributions from IRAs. [408(d)(1).] A distribution from a retirement plan account is deemed to carry out proportionate amounts of the pre- and after-tax contributions held in the retirement plan account. [IRC 72(e)(8)(A), (B), (5)(D).]

Aggregation Rule: However,  there is the ‘aggregation rule’ by which all IRA accounts are to be treated as one IRA, or contract, and all distributions in a calendar year are to be treated as one distribution from the aggregated IRA accounts. [IRC 408(d)(2).]

‘Cream-in-the-Coffee’ Rule:  This phrase was coined by noted IRA commentator Ed Slott. The principle that it conveys is that once the after-tax contributions (cream) is combined with the pretax contributions (coffee) in the retirement account, every ‘sip’ (distribution) taken from the retirement account will contain some cream and some coffee.

  • Differing Rules: Typical of most retirement account distribution rules, there are different ‘cream-in-the-coffee’ rules for IRAs than for qualified plan retirement accounts. Each rule starts with the same determination: how much after-tax (cream) contribution exists in the account. But after that, IRAs have their own rules separate from qualified plans. Adding to this confusion is that the rules of taxation under IRC 72 were written for distributions from annuity contracts, not retirement accounts, so all of these applicable distribution rules refer to a In an effort to try to keep this explanation simple, only the IRA ‘cream-in-the-coffee’ rule will be covered.
  • Exceptions: There are a handful of exceptions to the ‘cream-in-the-coffee’ rule: (i) a ‘returned’ IRA contribution is taxed outside the IRC 72 rules; (ii) qualified charitable distributions (QCDs) are deemed to come first from the pretax portion of the IRA; (iii) the transfer of funds from an IRA to a qualified health savings account (HSA) is deemed to come entirely from pretax funds until those funds are exhausted [IRC 408(d)(9)(E); and (iv) amounts transferred from an IRA to a qualified plan account( a roll-up)  are deemed to only come out of the pretax funds in the owner’s traditional IRA account, which can provide a planning opportunity for the IRA owner since the after-tax contributions remain with the IRA owner after the other funds are moved into the qualified plan account, enabling the owner to convert the retained after-tax funds to a Roth IRA. [IRC 408(d)(3)(H.)]

IRA Distribution Rules: Distributions from a traditional IRA are taxed under IRC 72, unless an exception applies. [IRC 408(d)(2).] A special aggregation rule applies to IRAs that does not apply to other retirement accounts. For purposes of determining how much of any particular distribution is a return of the IRA owner’s basis, all of the owner’s non-inherited IRAs are treated as a single, jumbo IRA. In other words, all traditional IRAs are aggregated. Thus, all distributions in a single calendar year from that single jumbo IRA are treated as one distribution to the IRA owner. This results in a formula that is then used to determine how much the IRA owner realizes as taxable income when he or she takes a distribution or converts funds from a traditional IRA to a Roth IRA. [Treasury Regulation 1.408A-4, A-7(a).]

  • IRA distributions that were rolled over to another traditional IRA or qualified retirement plan are not included in the distribution amount for purposes of this formula.

Example: On September 1 Jeff converts his entire traditional IRA to a Roth IRA. The IRA balance at the time of the conversion is $50,000, of which $40,000 represents after-tax contributions to Jeff’s IRA. On December 15 of the same year, Jeff retires from his employment and he receives a distribution of $450,000 from his former employer’s 401(k) account, all of which is pre-tax contributions. Jeff rolls his 401(k) distribution into a traditional IRA on December 16. Jeff makes no other contributions to, and he receives no other distributions from, any traditional IRAs for the balance of the calendar year. In Jeff’s mind, going back to August, he thinks he has made a Roth conversion that is only 20% taxable [$10,000 divided by $50,000.] However, Jeff’s December distribution of his 401(k) funds into a traditional IRA alters the Roth conversion fraction. Jeff’s ‘cream-in-the-coffee’ fraction applies to his Roth conversion as follows:

  • Distribution (conversion) Amount: $50,000
  • Total Nondeductible Contributions (Jeff’s basis): $40,000
  • End of Calendar Year IRA Account Balance: held by Jeff: $450,000
  • Outstanding Rollovers: $0.00
  • Return of Jeff’s Basis on Roth Conversion = $50,000 X [$40,000 divided by ($450,000+ $50,000] = $4,000.

Therefore, the amount of gross income that Jeff must report on his August Roth IRA conversion is $46,000 ($50,000 conversion less $4,000 basis allocated to the conversion.) Jeff’s remaining basis in his traditional IRA is $36,000 (the original $40,000 less $4,000 used in the Roth IRA conversion.)

Conclusion: Often when looking a taking a distribution from an IRA, or making a Roth conversion, overlooked are the ‘cream-in-the-coffee’ pro rata rule, and the ‘aggregation’ rules for determining the pro rata non-taxable amount of the distribution. The ‘snapshot’ is taken on a year-to-year basis, so the timing of rolling funds out of a qualified plan and into a traditional IRA needs to be factored into the analysis of the taxation of the IRA distribution.