“My client wants to take an in-service distribution from his 401(k) plan and roll it to an IRA. He wants to know if he should roll it to a new, separate IRA (i.e., a conduit IRA) or if it is OK to commingle the rollover with the assets in his existing IRA?”
ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor from Florida is representative of a common inquiry related to qualified plan-to-IRA rollovers.
Highlights of the Discussion
While there is no law or regulation that requires an individual to segregate assets rolled over from a qualified retirement plan in a separate or conduit IRA that holds only those assets, there are some tax and creditor protection reasons why your client may want to consider a conduit IRA. Below are three examples.
Retain the ability to roll the assets back to an employer-sponsored plan.
If your client intends to roll over the IRA assets that originated in a qualified retirement plan to another qualified retirement plan at a later date, he should be aware that some retirement plans will only accept rollovers that have been maintained in a conduit IRA and not commingled with other assets. Plan language will dictate which assets from an IRA, if any, a plan will accept as a rollover.
Preserve certain tax benefits for those born before January 2, 1936.
Plan participants who were born before January 2, 1936, who receive lump-sum distributions from qualified plans may be able to elect special methods of figuring the tax on the distributions. First, assets in the plan from active participation before 1974 may qualify as capital gains, subject to a 20 percent tax rate (instead of ordinary income tax rates). Second, such individuals also may be able to use a 10-year tax option (i.e., 10-year forward averaging) to figure the taxes on the ordinary income portion of their lump sum distributions. This special option allows an eligible individual to figure the tax on his/her lump-sum distribution by applying 1986 tax rates to 1/10th the amount of a lump sum distribution, then multiplying the resulting tax amount by 10. This tax is payable for the year in which a person receives the lump-sum distribution. Taxpayers who qualify for the capital gains or 10-year forward averaging tax treatments who are contemplating a rollover must use a conduit IRA in order to preserve their ability to take advantage of these options should they later roll the assets back to a qualified plan (IRS Fast Sheet 2003-04).
Ensure creditor protection in bankruptcy is preserved.
As a result of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, individuals can exempt certain qualifying assets from their estates for bankruptcy protection. Assets in a defined contribution plan (including a 401(k) plan), or in a defined benefit, 403(b), 414, 457 or 501(a) plan are protected from bankruptcy in their entirety with no limit. Even old “Keogh” plans (qualified retirement plans for owner-only businesses) have unlimited protection in bankruptcy situations. Assets rolled over from one of the protected plans to an IRA retain the unlimited bankruptcy protection given to them while held in the plan. In contrast, contributory assets in a traditional or Roth IRA are protected from bankruptcy up to the 2020 limit of $ $1,362,800 (i.e., 1,000,000 adjusted periodically for inflation). When determining bankruptcy protection, it may be advantageous from a recordkeeping standpoint for an individual to keep rollover assets from a retirement plan in a conduit IRA separate from assets in his/her contributory IRA.
While not mandated by the IRS or DOL, conduit IRAs may still play a helpful role for some individuals. Before completing a qualified plan-to-IRA rollover, it would be prudent for plan participants to consult with their tax and legal advisors about whether they would benefit from using a conduit IRA.