Reverse Rollovers Revisited

Take-Away: For those interested in establishing a Roth IRA to save income taxes in their future retirement years, they might want to consider a reverse rollover to move after-tax contributions to a Roth IRA with little, or no, income tax consequences.

Note: This is a ‘refresher’ summary of an earlier missive on reverse rollovers to a qualified plan account from an IRA.

Background: As was covered in the past, a reverse rollover is when traditional  IRA assets are moved to a qualified plan account  in hopefully a tax-free transaction. However, for this opportunity to exist,  the qualified plan must formally allow IRA funds to be added to the participant’s qualified plan account. Accordingly, not all IRAs can be moved, or rolled over, into a qualified plan account.

Why a Reverse Rollover: The question is why would any IRA owner want to do a reverse rollover? The technical reason is that with a reverse rollover only pre-tax contributions can be moved from the traditional IRA  into the qualified plan. For those IRA owners who are interested in a backdoor Roth IRA contribution, a reverse rollover is one way in which to segregate the pre-tax and after-tax contributions held in the traditional IRA. Thus, using the common phrase that explains the Tax Code’s pro-rata rule, a reverse rollover separates the cream-from-the-coffee in the IRA, facilitating the Roth IRA conversion.

• Backdoor Roth Conversion: A backdoor Roth IRA conversion is one where after-tax dollars are initially contributed to a traditional IRA. As soon as practicable after that IRA contribution, the traditional IRA is then converted to a Roth IRA. If the timing is close, there will be little, if any, taxable income that the IRA owner will have to recognize on the conversion from the traditional IRA to the Roth IRA.
• Pro-rata Rule: Recall that the pro-rata rules looks at all of an individual’s non-Roth IRA accounts (which includes SEP and SIMPLE IRAs) of the year of the Roth IRA conversion. If the individual account owner wants to convert of their IRA assets to a Roth IRA, and he/she has any pre-tax funds as of December 31 in any of their IRAs, a portion of the amount converted to the Roth IRA will be taxed in the year of the conversion.
• Reverse Rollover: If the traditional IRA owner has the opportunity to roll over his/her pre-tax IRA contributions to a qualified plan, like a 401(k) account during the calendar year, the IRA owner will be left with only after-tax contributions in their traditional IRA as of December 31 of that year (the ‘snapshot’ date.) Thus, the conversion of the traditional IRA, holding only after-tax contributions, to a Roth IRA will possibly be tax-free.
• Reversing the Reverse Rollover: Assuming a traditional IRA owner does a reverse rollover, and then converts his/her remaining traditional IRA (holding only after-tax contributions)  to a Roth IRA, there is nothing to prevent the same individual rolling over his/her 401(k) funds back into their traditional IRA in the next year, e.g. the account owner likes the greater flexibility of investments associated with a traditional IRA compared to the investment options selected by their employer for their 401(k) account.

Advantages and Disadvantages: This  ultimately results in a comparison of when to hold retirement funds in a qualified plan versus when to hold the same funds in an IRA.

A qualified plan account might be warranted due to the following considerations-

1. Still Working Exception: If the individual is age 72 or older, he/she will have to start taking required minimum distributions (RMDs.) RMDs may not have to be take from a qualified plan account if the participant is still working, g. a part-time employed individual over the age of 72. This is not the case with regard to funds that are held in a traditional IRA. Once the IRA account owner has reached their required beginning date (April 1 of the year after they reach age 72) they are required to take an RMD. Not so with regard to retirement funds held in their qualified plan accounts.
2. Avoid the 10% Early Distribution Penalty: If a plan participant leaves their employment at age 55 (or age 50 or older for some public safety employees) that individual can take a distribution from their qualified plan account without triggering the 10% early withdrawal penalty. That is not the case with a traditional IRA owner; he/she must delay taking any distribution from their traditional IRA until they attain age 59 ½ in order to avoid the 10% early distribution penalty.
3. Borrowing Allowed: Some qualified plans will allow a plan participant to borrow from their qualified plan account. The Tax Code is clear that an individual cannot ‘borrow’ from their IRA- it will be treated as a taxable distribution. Like the reverse rollover, this is a decision (ability to borrow) that is made by the qualified plan sponsor.
4. Creditor Protection: Some states have favorable laws that exempt qualified plan assets from creditor claims, while the same states limit the amount held in a traditional IRA that is exempt from creditor claims. Similarly, if the account owner is in bankruptcy, there is a dollar limit (about $1.5 million) that can be held in a traditional IRA that is free from the bankruptcy trustee’s collection efforts, while an unlimited amount held in the bankrupt-plan participant’s account will be exempt in their bankruptcy.
5. Administrative Fees: Often the administrative and investment fees that are associated with investments held in a qualified plan account are lower than the fees associated with a traditional  IRA.

A traditional IRA might be more beneficial in which to hold retirement funds when-

1. Accessibility: While an IRA owner can access his/her IRA account at any time, often there are constraints associated with a qualified plan account when access is limited to specified events in the qualified plan document, e.g. death, disability, termination from employment.
2. Exceptions to the 10% Penalty: The Tax Code contains several exceptions to the 10% early withdrawal penalty associated with distributions from traditional IRAs that are not available to a qualified plan account participant. Examples include IRA distributions for higher education purposes and first-time home purchases, neither of which attract the 10% penalty as an early distribution, but would if the distribution came from the qualified plan.
3. Investment Options: As noted earlier, there are usually many more investment options available for funds that are held in a traditional IRA when compared to the investment options that are associated with a qualified plan, like a 401(k) account.

Conclusion: There has always been a lot of interest in establishing a Roth IRA, due to its (i) tax-free income; and (ii) avoidance of an RMDs once the Roth owner attains age 72. The Proposed SECURE Act Regulations give even more impetus to own a Roth IRA, since at death the designated beneficiary can delay taking any distribution from the Roth IRA for at least 10 years, which is not the case with an inherited traditional IRA if the deceased account owner was older than their required beginning date. A reverse rollover is just one more way to engage in a backdoor Roth conversion without paying a large tax bill in the year of that conversion from a traditional IRA to a Roth IRA.