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

12-Aug-19

Reverse Rollovers

Take-Away: While most of us are familiar with IRA rollovers, and several of my missives over the past few years have dwelled upon the dangers of using a 60-day rollover, not much has been written about a reverse rollover, or roll-up, where an IRA balance is transferred to a qualified plan, like a 401(k) account. For older individuals who want to continue to work beyond age 70.5, a reverse rollover to their employer’s qualified plan can provide some attractive tax benefits.

Background: A qualified plan can choose to accept IRA transfers from plan participants; however, such a provision is not required by the Tax Code, it is strictly optional for the employer to add a reverse rollover provision to the qualified plan that it sponsors. Similarly, the plan may limit roll-ups to only active plan participants, thus making the option unavailable to non-active plan participants, e.g. former employees who retain their account in their former employer’s plan. According to the Plan Sponsor Council of America over 30% of 401(k) plans do not accept incoming reverse rollovers.

  • Eligibility: Only traditional IRA funds are eligible to be rolled-up into the qualified plan. SEP IRAs and SIMPLE IRAs are treated as traditional IRAs, so they too can be rolled-up into a qualified plan. After-tax contributions to an IRA are not eligible to be rolled-up. Nor are Roth IRAs eligible to be rolled-up into a qualified plan, even if the qualified plan contains a Roth-401(k) retirement plan feature.
  • Transfer of Funds: A reverse rollover is made the same way as a conventional IRA rollover to a new IRA. The transfer of IRA funds can be either through a direct custodian to plan trustee transfer, or by the use a 60-day rollover [which obviously carries with it the tax and penalty dangers if the 60-day deadline is missed.]

Advantages of a Reverse Rollover: Some possible benefits that are associated with the transfer of existing IRA funds to a qualified plan account in a reverse rollover include the following:

  • Delay Required Minimum Distributions: We have covered this topic in the past. Normally with a traditional IRA, the IRA owner must begin to take their required minimum distributions (RMDs) once age 70 ½ is attained. That is not true, however, if the funds are held in a qualified plan and the plan participant is still working. The still working exception to the RMD rules apply if: (i) the qualified plan adopts the still working exception for its participants; and (ii) the still working participant does not own directly or indirectly (through rules where ownership by family members is attributed to the participant) 5% of the company. Example: Charlie, who turns 70 next year, will have to take an RMD of his $1.0 million IRA, or about $36,000 next year. Charlie is still working for his employer. Charlie owns no part of the company. Charlie participates in his employer’s 401(k) plan. That qualified plan accepts reverse rollovers for its active participants. Charlie transfers the entire $1.0 million of his IRA to his 401(k) account in a reverse rollover. Charlie thus avoids having to take a taxable $36,000 RMD from his IRA next year- thus deferring the income tax on that $36,000 distribution until Charlie finally retires.
  • Enhanced Creditor Protection: We have also covered this topic in the past. The assets held in a qualified plan account are normally exempt from seizure in a bankruptcy proceeding. While IRAs are also protected in bankruptcy, there is a dollar limit on what IRA amount can be exempt from creditor claims in bankruptcy. Currently the dollar limit of an IRA that can be shielded in bankruptcy is $1,362,800. Consequently, if there exists the concern of a future bankruptcy, and a substantial amount is held in the owner’s traditional IRA in excess of that dollar limit, a reverse rollover of the excess amount to a qualified plan account should shelter that excess amount, if that transfer occurs well before the owner’s actual filing for bankruptcy. Along the same lines, even if bankruptcy is not a concern, state laws that exempt creditor claims from IRAs vary around the country. Some states impose a dollar limit on the amount held in a traditional IRA that is free from creditor claims. Federal law, not state law, governs qualified plan accounts including the federally imposed spendthrift limitation that is designed to preserve qualified plan account balances to be used in the participant’s retirement (and not before.) Accordingly, if there is a concern that a state’s IRA creditor exemption laws will not fully protect a traditional IRA balance, a reverse rollover of the owner’s IRA balance to a qualified plan should provide complete protection to those former IRA assets.
  • Avoid ‘Early-Distribution’ Rule: Assume that the IRA owner will need funds between the ages of 55 and 59 years. If a distribution is taken from the traditional IRA, the owner will pay both an income tax and the 10% penalty for the early withdrawal from the IRA. If the traditional IRA funds are rolled-up to a qualified plan account, the plan participant can avoid the 10% early distribution penalty if the owner separates from service and the participant is then age 55 or older. If no separation from service from the employer is contemplated, the participant can borrow against his/her account balance in the qualified plan. Recall that no funds can be borrowed from an IRA.
  • ‘Back-Door’ Roth IRA Conversions: A ‘back-door’ Roth IRA is one where a traditional IRA is funded, and then subsequently converted by the IRA owner to a Roth IRA. It is used when the contributor has high income and thus is not eligible to make a direct Roth IRA contribution. This ‘back-door’ Roth IRA conversion is limited if that the owner has other existing pre-tax IRA accounts. This limitation is because the Tax Code imposes a pro-rata rule, which governs IRA distributions when the owner has both pre-tax and post-tax IRA accounts. The IRS treats the conversion of a traditional IRA to the Roth IRA as a distribution of the traditional IRA. Due to the pro-rata rule, when that conversion is made, a portion of the converted amount equal to the ratio of the owner’s total pre-tax IRA accounts to the value of all of the owner’s IRA accounts (both pre-tax and after-tax) is taxable. While the ‘back-door’ Roth IRA strategy is not eliminated, it causes an income tax to be paid on the conversion. By doing a reverse rollover of the pre-tax IRA balance, that income tax can be avoided, since the pre-tax IRA can be rolled-up to the qualified plan account, which then leaves only after-tax IRA funds in the name of the owner when the pro-rata rule is applied on the Roth conversion.

Disadvantages of a Reverse Rollover: There are, however, some inherent limitations when retirement funds are ‘parked’ in a qualified plan account.

  • Spousal Consent: If a plan participant wishes to name a non-spouse as the beneficiary of the qualified plan account balance, spousal consent to that non-spouse beneficiary will be required. This is particularly troublesome (and awkward) in second-marriages where the participant-spouse wants to name children from a prior marriage as the beneficiaries of his/her qualified plan account. IRAs do not require any spousal consent to naming a non-spouse as the IRA beneficiary on the owner’s death.
  • Account Splitting: For estate planning purposes, an IRA owner may want to split his/her IRA into multiple IRAs, e.g. one naming charities as the beneficiaries, another for a surviving spouse, and yet another for children from a prior marriage. This type of ‘splitting’ of a qualified plan account balance can be accomplished only through a beneficiary designation where all beneficiaries are named, and if a future challenge arises, all qualified plan account funds are held ‘hostage’ pending the resolution of that challenge. In short, estate planning with an IRA is much easier than with a qualified plan account balance.
  • Accessibility: With an IRA the owner can access the funds at any time (subject, of course, to the inherent income tax liability and the 10% early withdrawal penalty if then under age 59 ½.) In addition, in some cases, the 10% penalty can be completely avoided for special uses for the withdrawn IRA funds, such as first-time homebuyers; payment of health insurance premiums while unemployed; higher education expenses; and if the SECURE Act passes, for adoption and birth expenses.  Often access to a qualified plan account balance is limited under the plan document to specified events, e.g. leaving the job; disability; or financial hardship.
  • Investments: There is a lot more flexibility in how an IRA can be invested by its owner, with only a narrow group of investments that are statutorily prohibited. In contrast, with a qualified plan, the investment choices for the account balance are limited to those that are selected by the plan sponsor.

Conclusion: Clearly there are pros and cons associated with a reverse rollover of a traditional IRA (or SEP IRA or SIMPLE IRA) to a qualified plan account. Avoiding RMDs from the traditional IRA may be reason enough to consider a reverse rollover for a still working plan participant. However, against that tax deferral must be balanced the required spousal consent imposed by ERISA and the limited access to the funds held in the qualified plan account.