Rolling over your 401(k) or other employer-sponsored retirement plan to an IRA can be a savvy financial decision. By consolidating your retirement savings into a single account, you can simplify the management of your finances and stay on track toward your financial goals. But certain cases are more complex than others, so it’s important to read the fine print.
Rollover Basics
You can roll over a retirement plan to a traditional or Roth IRA when you leave your employer—or even while still employed—if your plan allows in-service distributions after age 59 ½. Generally, you can transfer your plan proceeds directly to your IRA without tax withholdings.
Alternatively, if the proceeds are sent directly to you, you must deposit them in your IRA within 60 days. In this scenario, your plan’s administrator may be required to withhold 20% for taxes. And since withholdings are treated as a plan distribution, you’ll need to make up the difference by contributing outside funds to avoid triggering income tax.1 For that reason, if given a choice, most investors prefer a direct rollover between their plan and their IRA.
With those ground rules in place, let’s explore some more nuanced scenarios.
Creditor Protection
Most employer-sponsored retirement plans, including SEPs and SIMPLE IRAs, are exempt from federal bankruptcy laws.2 But traditional and Roth IRAs are only exempt up to $1,512,350 for 2023. What if you’re rolling over funds from an employer-sponsored plan? The IRA retains the full allowance under the bankruptcy code.3 For that reason, it’s best to keep rollover IRAs separate from contributory IRAs to maintain this valuable protection.
It’s also important to consider the impact of an inheritance. Spouse or non-spouse beneficiaries inheriting an employer-sponsored retirement plan still benefit from its exemption under federal bankruptcy law. The same can’t be said for inheriting a contributory or rollover IRA as a non-spouse beneficiary.4
Creditor protection also matters outside of bankruptcy proceedings. For instance, ERISA’s anti-alienation provision shields employer-sponsored retirement plans from state attachment and garnishment proceedings.5 But the protection of IRAs, including rollover IRAs, depends on the participant’s state laws. It’s crucial to be aware of these laws and take steps to safeguard retirement savings from potential creditors.6
After-Tax Contributions and Company Stock
Are you in one of the roughly 21% of 401(k) plans that allow after-tax contributions?7 Such plans allow participants to save in excess of pretax elective deferrals or Roth contribution limits.8 If so, you have the option to roll the principal of your after-tax contributions to a Roth IRA while rolling the pretax balance (including any earnings on your after-tax contributions) into a traditional IRA.9 Keep in mind, this treatment is available only if you’re distributing all the plan assets. For partial withdrawals, the distribution will be deemed to consist of pretax and after-tax balances proportionately.10
Withdrawing employer securities from your plan adds another wrinkle. If you do so as part of a lump-sum distribution,11 you will only pay ordinary income tax on the cost basis of the stock.12 Under current tax law, the net unrealized appreciation (NUA)—the difference between the current market value of the employer stock and its cost basis—is taxed at the long-term capital gains rate when the stock is eventually sold.13
The trade-off of distributing employer stock (instead of rolling it to an IRA) is the loss of tax deferral. However, you can often make up for this by applying the more favorable long-term capital gain tax rate to the NUA for low-cost basis employer securities. Plus, if you go this route, you can still roll the remaining plan balance not held in employer stock to an IRA to benefit from continued tax deferral of these assets.14
Transfers Between Spouses
Before completing a retirement plan rollover, married couples should understand the different treatment of IRAs and employer-sponsored retirement plans when it comes to Qualified Domestic Relations Orders (QDROs).15 QDROs allow retirement plans and IRAs to be transferred to a spouse or former spouse tax-free. While QDROs are commonly used in divorce settlements to divide IRA or plan assets, they can also be used by happily married couples to transfer employer-sponsored retirement plan assets (not IRA or rollover IRAs) to a spouse for estate and wealth transfer planning purposes.16 Rollovers from retirement plans should therefore be considered against the backdrop of wider estate and wealth transfer planning goals.
Estate and Beneficiary Rules
While employer-sponsored plans must be entirely distributed to the surviving spouse of a married participant unless the spouse waives this right, there is no such requirement for IRAs (except for SEP and Simple IRAs in some cases).17 However, surviving spouses may still have rights to IRA assets under applicable state laws. For that reason, when establishing a rollover IRA, it’s crucial to take proactive steps to ensure beneficiary designations are properly executed and coordinated with your broader estate and wealth transfer plans.
RMDs Add Another Twist
Required minimum distributions (RMDs) from 401(k)s and other retirement plans must begin at the later of age 73 or retirement from the sponsoring employer, with a “Still Working” exception for those who don’t own a 5%18 or more interest in the employer.19 However, minimum distributions from IRAs, Simple IRAs, and SEP IRAs must begin at age 73, regardless of employment status.
Backdoor Roth Contributions
The backdoor Roth contribution strategy is a popular workaround for income-restricted taxpayers.20 It involves making post-tax contributions to a traditional IRA, then quickly converting it to a Roth IRA. Since the traditional IRA contribution is non-deductible, the conversion is tax-free as long as the participant holds no other pretax IRA assets.
But a rollover IRA may limit your ability to make these tax-free backdoor Roth contributions. That’s because rollover and contributory IRAs are aggregated for distribution rules—unlike employer-sponsored plans.21 As a result, if your IRA holds pretax assets, any conversion will consist of a proportional share of pretax IRA assets and after-tax IRA contributions. The bottom line? Income tax will be triggered unless the participant’s IRA assets consist solely of after-tax contributions.
Roll With It
In the end, rolling over your retirement savings can be a wise choice, but it’s not a one-size-fits-all solution. Whether you’re looking to simplify your finances or navigate a more complex case, it’s important to weigh the pros and cons and consult with your Bernstein advisor. With the right guidance, you can roll with the changes and reach your retirement savings goals.
Recent research projects that from now through 2045, baby boomer households will transfer over $53 trillion to younger generations and charity as part of the “great wealth transfer.” While some of these handovers will occur at an individual’s passing, lifestyle changes and tax planning are spurring many to consider lifetime wealth transfers.
Recent research projects that from now through 2045, baby boomer households will transfer over $53 trillion to younger generations and charity as part of the “great wealth transfer.” [1] While some of these handovers will occur at an individual’s passing, lifestyle changes and tax planning are spurring many to consider lifetime wealth transfers.
[1] https://www.cerulli.com/press-releases/cerulli-anticipates-84-trillion-in-wealth-transfers-through-2045
- Robert Dietz, CFA
- National Director, Tax Research—Investment & Wealth Strategies
- Clay Oh, CFP®
- Analyst—Investment & Wealth Strategies
1 Retirement plan to IRA rollovers are not subject to the one rollover per year rule, unlike IRA-to-IRA rollovers. This allows for multiple rollovers between retirement plans and IRAs in the same year. Only one rollover from an IRA to another (or the same) IRA in any 12-month period is permitted, regardless of the number of IRAs owned. See IRS Announcement 2014-15 and Announcement 2014-32. The limit applies by aggregating all IRAs, including SEP and SIMPLE IRAs as well as traditional and Roth IRAs, effectively treating them as one IRA for purposes of the limit. The one-per-year limit does not apply to: (1) rollovers from traditional IRAs to Roth IRAs (conversions), (2) trustee-to-trustee transfers to another IRA, (3) IRA-to-plan rollovers, (4) plan-to-IRA rollovers, and (5) plan-to-plan rollovers.
2 11 U.S. Code § 522(d)(12). Retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986
3 11 U.S. Code §522(n). However, rollovers from a SEP or SIMPLE IRA seem to be excluded from this protection and therefore are exempt up to only $1,512,350 inflation adjusted.
4 Clark, 714 F.3d 559 (7th Cir. 2013), cert. granted, No. 13-299 (U.S. 11/26/13)
5 ERISA §206(d) and 29 U.S. Code §1056(d)(1), Treas. Regs. §1.401(a)-13(b)(1)
6 In addition, owner-only plans such as solo 401(k) plans where there is a single participant, or the only other participant is the owner's spouse, are at risk under non-bankruptcy state creditor proceedings. Finally, while SEP and SIMPLE IRAs have unlimited protection under federal bankruptcy law, the anti-alienation provision of ERISA does not apply. As a result, SEP and SIMPLE IRAs may not be protected under state law for non-bankruptcy actions.
7 PSCA’s 2022 65th Annual Survey of Profit Sharing and 401(k) Plans.
8 Participants can contribute up to $22,500 pretax to a 401(k) plan or after-tax to a Roth 401(k). An additional $43,000 of capacity is available for employer matching contributions. Absent employer contributions, a plan may permit this additional capacity can be used for non-deductible (after-tax, non-Roth) participant-directed contributions. Participants aged 50 or older can make an additional $7,500 catch-up contribution to the plan, bringing their total contribution limit to $73,500. As a result of the SECURE 2.0 Act (Pub. L. No. 117-328), earners making $145,000 or more must make catch-up contributions to a designated Roth account rather than on a pretax basis beginning in 2024. IRS Notice 2023-62 provides a two-year administrative transition period which effectively delays the starting date to 2026.
9 See IRS Notice 2014-54.
10 Id.
11 IRC § 402(e)(4)(A)
12 IRC § 402(e)(4), Treas. Reg. § 1.402(a)-1(b)(2)
13 Treas. Reg. § 1.402(a)-1(b)(1)(i); Notice 98-24, 1998-1 C.B. 929; PLR 2004-10023
14 See PLRs 2004-10023, 2001-38030, 2001-38031, 2000-38052, 2000-38057, 9721036.
15 IRC § 414(p)(1)
16 IRC § 408(d)(6), see U.S. Department of Labor, The Division of Retirement Benefits Through Qualified Domestic Relations Orders, Question 1-8.
17 IRC §§ 401(a)(11) and 417(a)(2), Treas. Reg. §§ 1.401(a)-20, A-12(b) and 1.417(e)-1
18 IRC § 401(a)(9)(C)(i)(II)
19 IRC § 401(a)(9)(C)(ii)(I)
20 Modified AGI (MAGI) income limits on Roth IRA contributions for the 2023 tax year are $153,000 for single filers and $228,000 for married couples filing jointly
21 IRC § 408(d)(2)