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Unlocking the Benefits of a Reverse Rollover Strategy

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What You Need to Know

  • Moving funds from an IRA to a 401(k) can help some clients avoid RMDs or access money earlier.
  • But IRAs have some advantages, like the ability to hold nontraditional assets.
  • As with any financial planning strategy, consider your client's full financial picture first.

The Labor Department’s recently released investment advice fiduciary standard has highlighted the importance of rollover decisions when it comes to retirement planning.

When most clients think of rollovers, they think of the traditional 401(k)-to-IRA rollover — rollovers that might be employed several times throughout a typical client’s career, as they change employers over the years. The IRA-to-401(k) rollover — or reverse rollover — receives significantly less attention.

For some clients, however, moving funds from an IRA to a company-sponsored 401(k) can have its advantages. If the client’s 401(k) plan permits IRA rollovers, the reverse rollover strategy can have several key benefits that could help clients maximize the tax value of these pretax retirement savings vehicles.

Key Benefits of the Reverse Rollover Strategy

Almost every client knows that the general rules governing retirement accounts require nearly every individual account owner to begin taking required minimum distributions (RMDs) by age 72 (70½ prior to 2020). Despite this, if the 401(k) allows it, a client who transfers funds to a company-sponsored 401(k) can avoid RMDs if he or she remains employed with the employer that sponsors the plan. (The client can also continue to make contributions to the 401(k).) This is known as the “still working exception.”

RMDs from traditional IRAs are always required once the client reaches age 72 — regardless of whether the client has actually retired. For the still-working exception to apply, however, the plan must specifically allow the client to avoid RMDs, and the client can own no more than 5% of the company that sponsors the plan.

The client’s target retirement age can also be key to determining whether a reverse rollover is beneficial. For example, penalty-free distributions may be available from a 401(k) as soon as age 55 if the client retires (i.e., “separates from service”). IRAs, on the other hand, require the client to reach age 59 ½ to take a penalty-free distribution unless some other exception applies (such as a first-time home purchase or certain educational expenses). 

401(k)s can also provide access to funds in the form of loans, whereas IRAs do not have a loan option.

For some clients, creditor protection may also be an issue. 401(k)s typically provide stronger creditor protection than a traditional IRA. State law will determine the level of protection available, so clients should be sure to check local laws if creditor protection is a factor.

Clients who are interested in the backdoor Roth conversion strategy might also benefit from executing a reverse rollover prior to funding the Roth. If the client’s IRA contains both after-tax and pretax dollars, the withdrawal will usually be partially taxable. Rolling the pretax dollars into a 401(k) via the reverse rollover strategy can eliminate the client’s tax liability on the Roth conversion.

Potential Downfalls of a Reverse Rollover

IRAs are much more portable than company-sponsored 401(k)s. While the client must usually take active steps to move the 401(k) to consolidate accounts when changing jobs, the IRA is established independently of the employer. Clients who are considering a job change, therefore, might be inclined to leave their IRA funds in the IRA.

While clients generally have to wait longer for penalty-free access to an IRA, the exceptions to the early withdrawal penalty vary between the types of account. In other words, some of the early withdrawal exceptions that apply to IRAs might not be available in the 401(k) context.

Investment options offered (and fees charged by) either type of account, as well as the client’s desire to invest in nontraditional account assets such as real estate or precious metals, which can be accomplished through an IRA, also need to be taken into account. 

Conclusion

What’s best for any given client with access to both 401(k) and IRA options generally requires a detailed examination of the client’s particular circumstances and individual preferences. For some, the reverse rollover strategy can maximize the tax deferral benefits that traditional retirement accounts offer.

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