Take-Away: Not all funds held in a qualified plan retirement account are eligible for a rollover to an IRA.

Background: When individuals retire from employment, they frequently move their retirement fund accumulations from their former employer’s qualified plan, like a 401(k) plan, to the individual’s own IRA. The reasons for moving the retirement funds from the qualified plan to an IRA are numerous. Examples include: (i) IRAs typically offer more investment funds; (ii) IRA funds are more easily accessible, at any time; (iii) qualified charitable distributions (QCDs) can only be made from an IRA; (iv) consolidating all retirement funds into a single IRA simplifies keeping track of beneficiary designations; (v) estate planning is presumably easier to implement, e.g. a spouse’s consent is not required to change the beneficiary designation of an IRA, unlike a qualified plan account where the participant spouse’s consent is required to change a beneficiary designation; and (vi) IRA distributions do not require federal tax withholding, but qualified plan distributions eligible for rollover distributions are subject to a 20% withholding if the funds not rolled over directly from the qualified plan directly to the IRA custodian.

Eligible Rollover Distributions: However, not all company plan distributions are eligible for a rollover to an IRA (deemed, eligible rollover distributions.) Accordingly, it is important to determine if the funds held in the employer’s qualified plan are, in fact, eligible rollover distributions. Unfortunately, the Tax Code does not specifically list which qualified plan distributions are eligible rollover distributions. Rather, the Tax Code identifies those distributions that are not eligible rollover distributions. The short list of the non-eligible rollover distributions follows:

  1. RMDs: A required minimum distribution (RMD) for the year of retirement must come out of the participant’s qualified plan account first, before the balance can be rolled over into an IRA. Consider the ‘still working’ plan participant who is over the age of 72 who decides to finally retire. Their intent is to roll over the entire balance of their qualified plan account to an IRA. The RMD for the year of the ‘still working’ participant’s retirement must be taken out from the plan first- it cannot be rolled over to the retiree’s IRA.
  2. Periodic Payments: If a plan participant is taking substantially equal periodic payments (SEPP) under IRC 72(t), those retirement fund distributions cannot be rolled over to an IRA.
  3. Hardship Distributions: Some qualified plans permit a hardship distribution to the plan participant. However, a hardship distribution is not permitted to be rolled over to an IRA. This limitation prevents the participant from circumventing the rules by rolling over funds that he/she had claimed were required to address their immediate financial need.
  4. Non-Spouse Beneficiary Distributions: Non-spouse qualified plan designated beneficiaries (like IRA beneficiaries) cannot engage in a 60-day rollover. They must do a direct transfer of their inherited qualified plan retirement funds from the qualified plan directly to their IRA custodian.

Penalty: As has been covered in the past (repeatedly!), if any non-eligible rollover distribution is in fact rolled over to an IRA, it becomes an excess IRA contribution that must be timely removed from the IRA in order to avoid the annual six percent (6%) excise tax. Any rollover that is done after 60 days will be treated as an excess contribution, subject to penalty unless it is promptly corrected.

365-Day Rule: On the good news front, the one-time-per-365-day rollover limit under the Tax Code, does not apply to a qualified plan-to-IRA-rollover.

Conclusion: Financial advisors are now being closely scrutinized by various governmental regulators when they counsel their clients to engage in a qualified plan-to-IRA rollover. Thus, it is important to inform clients who are considering a qualified plan-to-IRA rollover of the pros-and-cons of a rollover, identify what retirement funds are non-eligible rollover distributions, and document those informed conversations.