An individual who is planning to retire will often roll over the assets in her qualified plan into a traditional IRA, e.g., so that she will have more control over how the funds are invested.If the plan permits (and only if the plan permits), such an individual may also be able to roll over the assets in a traditional IRA to one of the following types of plans:
* An Internal Revenue Code §401(a) qualified plan, which would include a 401(k) plan;
* An IRC §403(a) annuity plan;
* An IRC §403(b) tax sheltered annuity; or,
* An IRC §457 governmental plan.
To qualify as a tax-free rollover, the amount received from the traditional IRA must be rolled over to an eligible retirement plan for the benefit of the individual for whom the traditional IRA was maintained; the rollover must be made not later than the 60th day after the day on which the individual receives the traditional IRA payment or distribution that is being rolled over, unless a hardship exception to the 60-day rollover requirement applies; and the maximum amount of the traditional IRA distribution that may be rolled over to an eligible retirement plan may not exceed the part of the amount distributed that would be includible in gross income if it weren't rolled over.
Observation: Thus, after-tax contributions to a traditional IRA may not be rolled over to a qualified plan, but deductible contributions and all earnings on contributions (including earnings on nondeductible contributions) can be rolled over.
Example 1: Your client has $180,000 in her traditional IRA, which consists of $45,000 of nondeductible contributions, $10,000 of deductible contributions and $125,000 of earnings on the contributions. She is also a participant in her employer's 401(k) plan, which permits rollovers to that plan from a traditional IRA. She may roll over $135,000 from her traditional IRA to the 401(k) plan.
Also note that any amount that would be a required minimum distribution for the year of distribution from the traditional IRA may not be rolled over.
Observation: Since, as pointed out above, rollovers from a traditional IRA to a qualified plan may be made only if the terms of the plan allow such a rollover, before withdrawing funds from a traditional IRA with the intention of rolling them over to an eligible retirement plan, the employee/IRA owner should make sure that the eligible retirement plan accepts such rollovers.
By rolling over all the deductible contributions and earnings in a traditional IRA to a qualified plan, the IRA owner would be able to do one of the following:
1. He would be able to withdraw funds left in the traditional IRA after the rollover completely free of tax and penalty or at little tax and penalty cost.
Example 2: The same facts apply as in Example 1. If your client rolls over all of her nondeductible contributions and earnings in her traditional IRA to her company's 401(k) plan, then immediately after the rollover she would be able to withdraw the $45,000 of nondeductible contributions remaining in her traditional IRA without including any of the amount withdrawn in her gross income, and without having to pay any penalty, even if she is under age 59-1/2 at the time of the withdrawal, and even if no other exception to the imposition of the penalty applies. This is because the early-withdrawal penalty is imposed only on amounts includible in gross income.
Observation: If the withdrawal in Example 2 is not made until there are some additional earnings on the nondeductible contributions left in the traditional IRA, then only those additional earnings would be includible in gross income. They also would be subject to the 10 percent early-withdrawal penalty if made before age 59-1/2, unless some other exception to the early-withdrawal penalty applies.
2. If otherwise eligible, the IRA owner would be able convert the funds left in the traditional IRA after the rollover to a Roth IRA without any tax cost.
Example 3: The same facts apply as in Example 2, plus your client is eligible to roll over the funds in her traditional IRA to a Roth IRA. If she rolls over the nondeductible contributions remaining in her traditional IRA to a Roth IRA immediately after the rollover of the deductible contributions and earnings to her company's 401(k) plan, no part of the amount rolled over would be includible in her gross income.
3. The owner would be able to withdraw the funds rolled over from the traditional IRA to the qualified plan (as well as other funds in the qualified plan) without penalty if service with his employer is terminated in the year he reaches age 55 or later, but before reaching age 59-1/2. Funds could not be withdrawn from a traditional IRA without penalty merely because service with the employer is terminated, unless some other exception to the early-withdrawal penalty applies. If the funds are in an eligible plan, there is no limit on the amount that could be withdrawn without penalty. This is so regardless of whether the termination of employment was voluntary or involuntary. Of course, the amount withdrawn would be includible in gross income.
Example 4: In 2006, when your client was 54, she rolled over $150,000 from her traditional IRA to her employer's 401(k) plan. In 2007, when she is 55, she quits her job and retires. At that time, the total amount in her 401(k) plan is $400,000, including the amount rolled over from her IRA. She will be able to withdraw any amount she wants from the 401(k) plan without penalty.
Rolling over funds from a traditional IRA to a 401(k) plan provides added flexibility for avoiding the early withdrawal penalty if a need for funds arises before attainment of age 59-1/2, e.g., because the IRA owner wants to retire early, or loses his job because of downsizings and outsourcings.
If left in the traditional IRA, funds will be able to be withdrawn penalty-free in many cases only if the IRA owner takes substantially equal periodic payments. While there is a fairly large degree of latitude in fixing the level of payments under three methods approved by the Internal Revenue Service in Rev. Rul. 2002-62, it will not be possible, without being subject to the 10 percent early-withdrawal penalty, to change them (except in cases of death or disability) before the later of the date that the IRA owner is 59-1/2, or the end of the five-year period beginning with the date of the first payment.
Thus, by making a traditional-IRA-to-plan rollover, an individual who expects to leave employment after attaining age 55 but before attaining age 59-1/2 will be in a position to use the age 55 exception to the penalty and gain the added flexibility it offers compared to the substantially equal periodic payment exception available for withdrawals from the IRA.
Caution: If an IRA owner rolls over amounts in his traditional IRA to an eligible plan, and his employment is not terminated, and he needs to withdraw funds from the plan, he may not be able to do so without penalty if all his funds are in the plan and not in his IRA. For example, substantially equal periodic payments may not be taken from a qualified plan without penalty until after termination of service. Similarly, distributions for certain higher- education expenses, and distributions for first-time homebuyers, may be taken from a traditional IRA without penalty before age 59-1/2, but not from a qualified plan.
Note also that in most cases, an IRA owner will have more investment choices if he keeps his funds in the IRA, instead of moving it into a qualified plan where his employer determines what investment choices are available.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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