For years the IRS held strong: When rolling over 401(k) funds, after-tax and pre-tax funds are distributed pro-rata. However, with the recent issuance of IRS Notice 2014-54, the rules have changed.
Historically, for those who maxed out their tax-deferred growth options, saving money in an after-tax 401(k) plan was not a great strategy. The IRS’ stance on pro-rata distributions made it impossible to convert after-tax funds in a 401(k) to a Roth IRA and pre-tax funds to a traditional IRA in tax-free transactions. Now, the IRS has reversed its prior position and taxpayers who wish to roll over their 401(k) funds may allocate the after-tax portion to a Roth IRA.