The IRS has recently blessed another option for your clients who are competing to maximize guaranteed lifetime income during retirement—the 401(k) to pension plan rollover.
This little-known technique can allow your clients to transform an ordinary 401(k) plan into an old-school pension that provides monthly annuity payments for life. For clients whose greatest fear is running out of money during retirement, this strategy can provide the peace of mind they need at a significantly lower cost than traditional commercial annuity strategies.
401(k) to Pension Plan Rollover: The Basics
For employees who work for an employer that offers both a defined contribution plan (DC), such as a 401(k), and a defined benefit plan (DB), or a traditional pension, a rollover technique allows employees to transfer their 401(k) funds into the pension plan when they leave employment or retire. The employee will then receive lifetime annuity payments based on the actuarial equivalent of the funds that were rolled over.
While we all know that 401(k) funds can be exhausted, the amounts rolled over into the pension will provide additional annuity payments for the remainder of the client’s life. The annuity payout is added to whatever payments the employee would receive under the traditional pension plan.
The IRS Provides Certainty
Earlier this year, the IRS issued a series of revenue rulings designed to encourage retirement planning by increasing the available options for achieving guaranteed lifetime income. In Revenue Ruling 2012-4, the IRS provided guidance that clarifies when an employer is permitted to allow employees to roll over their 401(k) funds into traditional pension plans without risking the disqualification of the pension.
The IRS made clear that as long as the annuity payments offered were based on the actuarial equivalent of the funds rolled over from the 401(k), the option will not cause the plan to be disqualified. In determining the actuarial equivalent, the employer must use the interest rates and mortality tables provided in IRC Section 417.
Before the IRS provided this guidance, it was rare to find employers that offered the 401(k)-to-pension plan rollover option because most were unwilling to risk the disqualification of their pension plans. Now that employers have clear guidelines to determine the amount of the annuity payouts, it is likely that the direct rollover option will become much more prevalent among employers offering traditional pension plans.
The 401(k)-to-pension plan rollover can be accomplished only if your client’s employer offers both a defined contribution plan, such as a 401(k), and a defined benefit plan, or a traditional pension plan. The employer also has to offer the rollover option, but, as mentioned, the certainty provided by the IRS will likely encourage employers to offer the option.
While defined contribution plans are widely offered today, many employers no longer offer traditional pension plans. Because of this, only employees who work for companies that continue to also offer pension plans will be able to take advantage of this rollover technique.
While the 401(k)-to-pension plan rollover strategy isn’t for every client, it provides an opportunity for some to increase their guaranteed lifetime income by contributing additional funds to their pension plans. Now that the IRS has provided certainty that the rollovers will not disqualify an employer’s pension plan, the opportunity will be seen more frequently.
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