Is a Reverse IRA-to-401(k) Rollover Right for Your Client?

Nearly every client is familiar with the concept of rolling funds from an employer-sponsored 401(k) into an IRA. The strategy is a common one for clients once they are no longer employed by the company sponsoring the 401(k)—and can also give the clients more control over the management of their retirement funds. On the other hand, rollovers from IRAs into company-sponsored 401(k)s are relatively rare. There are situations in which executing a “reverse rollover” from an IRA into a 401(k) can be advantageous, especially for clients who are interested in minimizing their RMD obligations upon hitting their required beginning date. That makes it valuable for advisors to brush upon the rules governing the reverse rollover strategy so they can help put clients in the best tax position possible.

The IRA-to-401(k) Rollover Strategy

Clients should first understand that a 401(k) plan is under no obligation to accept rollover contributions. While all 401(k)s must allow clients to transfer funds out of the 401(k) into an IRA, the reverse isn’t true. So, before considering the reverse rollover strategy, the client should check with their plan sponsor to determine whether rollovers are accepted in the first place.

Further, while clients may be entitled to roll pre-tax IRA dollars into a 401(k), the IRS does not allow taxpayers to roll nondeductible or Roth IRA contributions back into a company-sponsored 401(k). In situations where the client’s IRA contains both deductible and nondeductible contributions, the deductible contributions can be segregated and rolled over into the 401(k).

Benefits of the Reverse Rollover Strategy

While the benefits of a traditional 401(k)-to-IRA rollover are fairly clear, the benefits of executing a reverse rollover are less obvious. For the right client, the reverse rollover can allow the client to avoid taking required minimum distributions (RMDs) once the client reaches their required beginning age (which is currently age 73).

Under the “still working” exception for 401(k)s, the client is not required to begin taking RMDs even after reaching the required beginning date if the client continues to work for the employer that sponsors the plan. Note, however, that the client can only take advantage of the still working exception if the client does not own more than 5% of the company and the plan allows delayed RMDs. The rules governing IRAs do not allow for delayed RMDs even if the client continues to work after reaching their required beginning date.

An IRA-to-401(k) rollover can also help minimize the client’s tax liability if the client decides to execute a Roth conversion. Under the “pro rata rule”, the client must consider both deductible and nondeductible IRA contributions that exist as of December 31 of the year of conversion when funding a backdoor Roth using the conversion strategy.

If the client’s IRA contains pre-tax dollars and after-tax dollars, at least a portion of the amount converted will be taxed in the year of conversion. However, if the client rolls all pre-tax 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 pre-tax dollars into the 401(k), a smaller portion of the amount converted will be taxable).

Clients who are interested in taking a loan from their retirement plan may also be interested in the reverse rollover option. 401(k)s can allow participants to take loans from the plan, while IRAs do not offer a similar option (however, it’s important to check with the specific 401(k) because not all 401(k)s are required to offer plan loans).

Potential Pitfalls of the Reverse Rollover

As with any strategy, there are potential downsides that the client should consider before executing the reverse rollover. Both IRAs and 401(k)s impose a 10% penalty for early withdrawals. Each type of plan allows for exceptions that can allow the client to avoid the penalty in certain situations.

Those exceptions vary based on whether the account is a 401(k) or an IRA, so clients should carefully examine the various exceptions to determine whether they may need to take advantage of a particular exception in the future. For example, clients can avoid the 10% penalty for IRA distributions used to buy a first home, but the first-time homebuyer exception is not available for 401(k) early withdrawals.

Clients should also consider the various investment options available under each type of plan. IRAs tend to allow for a wider variety of investments, especially if the client is interested in nontraditional retirement investments, such as cryptocurrency and real estate. 401(k) investments are limited by the plan itself and tend to contain more traditional investment classes.

401(k)s also offer stronger creditor protection (protection offered for IRA funds can vary from state to state), so if creditor protection is an issue for the client, the reverse rollover strategy may not be ideal.

Conclusion

As with any type of investment strategy, advisors should carefully consider the client’s unique circumstances when recommending an IRA-to-401(k) rollover. For the right client, however, the strategy can provide valuable tax savings.

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