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

July 12, 2023

Plan to IRA Rollover? – Maybe Not

Take-Away: Sometimes an IRA rollover may not be the best decision for a retiring qualified plan participant.

Background: A staggering $2.9 trillion was moved from qualifed plan accounts to IRAs in the years 2016 to 2021. The Pew Charitable Trust reports that in just 2018 alone, $516.7 billion was rolled over from qualified plans to IRAs. But were those wise transfers of retirement funds from a qualified plan like a 401(k) account to an IRA? There might be some good reasons why a rollover of a qualifed plan balance to an IRA may not be always be the best decision.

Why a Rollover Might Not Be Such a Good Idea: There are some reasons, legal and financial, when rolling retirement funds from a qualified plan, like a 401(k) account, to an IRA may not make good sense for some plan participants.

Consider the following legal reasons why a an IRA rollover might not be a good idea:

Bankruptcy: If the retirement account owner is worried about a future bankruptcy, his/her 401(k) account is fully (100%) protected by the Employee Retirement Income Security Act [ERISA] in bankruptcy, regardless of the size of the balance of the 401(k) account. There is less ERISA protection for an IRC 403(b) annuity, but still much can be protected if a bankruptcy is filed by (or against) the 403(b) owner. There is no ERISA protection if the bankrupt-participant is in an IRC 457(b) retirement plan.With IRAs, there are different rules and different exception/exclusions in bankruptcy, e.g. a fixed dollar amount is protected if the IRA owner files for bankruptcy, with any excess exposed to be lost in the bankrutpcy proceeding.

Judgment Creditors: At the state level, if there are judgment creditor concerns, each state has its own IRA exemption laws, which vary from state to state. Often the state IRA creditor exemption law turns on the state where the retiree lives when the judgment is sought to be enforced, which means if a retiree moves from a rust-belt ‘protection’ state to a sunshine state, a different set of ‘protection’ laws will apply to the retiree’s IRA. This is not the case with a qualified retirement plan account which is protected from judgment creditor claims, nationwide, by the federal ERISA blanket protection for all qualified plan accounts, regardless of their balance.

Loans: A qualified plan may permit (the sponsor’s decision when the plan is created) a plan participant to take a loan from his/her 401(k) account. As a surprise to many IRA owners, no loan can be taken from an IRA, at any time. Any distribution from the IRA is a taxable distribution, often subject to the 10% excise tax for early distributions. Thus, if a retiree wants to access funds in his/her retirement account without incurring a big income tax bill, e.g. the down payment on a sunshine state retirement condominium, taking a loan from their 401(k) account might make more sense than a taxable distribution from a rollover IRA.

Life Insurance: An IRA cannot own a life insurance policy (along with a relatively short list of other prohibited investments, e.g., collectibles; precious metals.) A 401(k) plan may allow (again, the plan sponsor’s decision when the plan is initially established) the purchase of life insurance using retirement account funds. This investment option might be important to a client who wants to use life insurance death benefit as part of a legacy to his/her heirs.

Still-Working RMD Exception: When an IRA owner hits age 73, he/she is subject to taking taxable required minimum distributions (RMDs) from their IRA. The same RMD rule may apply to a qualified plan participant. However, if the plan participant is still working for the plan sponsor, and the participant is a less-than-5% owner of the plan sponsor, he/she can delay taking any RMDs until their actual retirement. If the still working plan participant has an IRA, they must still take RMDs from their ‘outside’ traditional IRA.

Age 55 or Age 50/25 Years Exception: There is a 10% excise tax imposed on a distribution from a retirement account when the account owner is less than age 59 1/2. However, there is an exception to the 10% early distribution excise tax if a plan participant separates from service from the plan sponsor after attaining age 55 years. Moreover, if the plan participant who separates from service is also a public safety employee, the exception age is lowered from age 55 to age 50 years, or if the public employee has completed 25 years of service if earlier. There are only a few statutory exceptions where the 10% early distribution excise tax is waived if distributions are taken from an IRA, e.g., disability; first home purchase; victim of domestic abuse.

Changing Trend?: In light of the large amounts that have been rolled over from qualified plan accounts to IRAs in recent years, it is somewhat surprising then to read the conclusion of a recent 2023 study conducted by The Cerulli Edge-U.S. Monthly Product Trends. That study found that 58% of sponsors of qualifed plans now actively seek to retain participant account assets, post-retirement.

Echoing this trend was another study conducted by Pontera which focused on the advice financial advisors gave to their clients in 2022 with regard to rollovers. The Pontera study found that 59% of advisors encouraged their plan participant clients to not do a rollover of their 401(k) accounts to an IRA in 2022 when retiring due to better financial benefits that are offered by their existing 401(k) accounts, (along with the advisor’s ability to effectively manage those assets held in the qualified plan.)  A couple of the reasons cited for this don’t do a rollover advice included:

  •  Lower Costs: If the retirement funds are held in a qualified plan, like a 401(k) account, the plan participant will access investment assets with lower fees (compared to higher fees associated with IRA investments) and also lower fees and expenses associated with institutional mutual funds that are available only through a qualified plan.
  • Employer Stock: Some qualified plans (admittedly more of a rarity) offer publicly traded stock of the sponsor to be a permissible retirement investment in a 401(k) account. This employer stock can provide several tax benefits when the employer stock is finally sold by the plan participant, the most important being capital gain taxation, as opposed to ordinary income taxation, on liquidation of the distributed employer-sponsored stock.

Conclusion: There can be reasons why a rollover of a 401(k) account balance to an IRA might not make the best sense, either from a legal, or a financial, perspective. As always, every situation is different. Since fiduciary responsibility requires that an advisor always do what is in their client’s best interest, probably more time should be spent looking at (and then documenting) the pros and cons of an IRA rollover when the plan participant retires with a 401(k) account.