Close Close
ThinkAdvisor
Robert Bloink and William H. Byrnes

Retirement Planning > Saving for Retirement

Can a Reverse Rollover Reduce Your Client’s Tax Bill?

X
Your article was successfully shared with the contacts you provided.

What You Need to Know

  • A reverse rollover can allow clients to minimize taxes on a Roth conversion or avoid RMDs once the client hits their required beginning date for the IRA.
  • Clients rolling an IRA into a 401(k) may have more limited investment choices and fewer penalty exceptions.
  • As with any retirement income planning strategy, it’s important to consider the individual client’s unique situation before executing a reverse rollover.

In the typical case, clients are interested in rolling 401(k) funds into an independent IRA, whether because they are changing employers, retiring or simply want more control over their retirement funds. However, there may be situations where a client can benefit from a “reverse rollover” strategy, where funds are moved from an existing IRA into an employer-sponsored 401(k).

Clients who are interested in executing a Roth conversion in today’s down market may be particularly attracted to the reverse-rollover strategy, as it can allow the client to minimize taxes on the conversion — or even avoid required minimum distributions (RMDs) once the client hits their required beginning date for the IRA.

Reverse Rollovers: The Basics

As an initial matter, the reverse-rollover strategy only works if the specific 401(k) plan in question accepts rollover contributions. While all employer-sponsored plans are required to permit participants to roll funds out of the plan and into an IRA, the reverse isn’t true — some 401(k)s may not accept rollovers at all. Clients should check with their plan administrator to determine whether their 401(k) allows rollovers.

Additionally, the client is only permitted to roll pretax, or deductible, IRA contributions into the 401(k). So, if the IRA contains both deductible and nondeductible (after-tax) contributions, only the pretax dollars are eligible for rollover to the 401(k). Similarly, Roth IRA funds cannot be rolled over into a traditional 401(k).

Clients can roll over their entire deductible IRA balance into a 401(k) without limit.

Tax Benefits and RMD Exceptions

There are many different reasons why a client might wish to roll IRA funds into their company-sponsored plan. If the client has reached age 72 and is still working, rolling IRA funds into the employer plan can allow the client to avoid or minimize RMDs under the “still working” exception for 401(k) RMDs (the client can only take advantage of the still-working exception if the client doesn’t own more than 5% of the company and the plan allows delayed RMDs).

A reverse rollover can also help reduce the client’s tax bill if the client is interested in executing a Roth conversion. Typically, the pro rata rule requires the client to consider both deductible and nondeductible IRA contributions that exist as of Dec. 31 of the year of conversion when funding a backdoor Roth using the conversion strategy.

If the client’s IRA contains pretax dollars, at least a portion of the amount converted will be taxable in the year of conversion. However, if the client rolls all pretax funds into the 401(k) during the year of conversion, the Roth conversion will be nontaxable (similarly, if the client rolls a portion of the pretax dollars into the 401(k), a smaller portion of the amount converted will be taxable).

The client’s 401(k) may also be subject to stronger creditor protection rules than an IRA (depending on the bankruptcy rules under state law).

The Limitations of Reverse Rollovers

While reverse rollovers have many benefits, there are also potential downsides. Clients may be able to avoid the 10% penalty for early IRA withdrawals in situations where an exception applies — yet that same exception may not be available under the 401(k) early-withdrawal penalty rules. For example, clients can avoid the 10% penalty for IRA distributions used to purchase a first home, but the first-time homebuyer exception isn’t available for 401(k) early withdrawals.

IRAs may also offer a wider array of investments, especially for clients interested in non-traditional retirement investments such as cryptocurrency or real estate. 401(k) investment choices may be more limited, depending on the specific plan.

Clients can also access their IRA funds (subject to penalty) at any time. With a 401(k), distributions can only be taken when a certain event occurs (i.e., reaching age 59½, separating from your employer or experiencing financial hardships).

Conclusion

As with any retirement income planning strategy, it’s important to consider the individual client’s unique situation before executing a reverse rollover. In the right situation, however, the option can provide significant tax benefits for the client.


  • Learn more with Tax Facts, the go-to resource that answers critical tax questions with the latest tax developments. Online subscribers get access to exclusive e-newsletters.
  • Discover more resources on finance and taxes on the NU Resource Center.
  • Follow Tax Facts on LinkedIn and join the conversation on financial planning and targeted tax topics.
  • Get 10% off any Tax Facts product just for being a ThinkAdvisor reader! Complete the free trial form or call 859-692-2205 to learn more or get started today.