Rollovers of IRAs to QPs: An overlooked source of planning possibilities

By Robert Adler

Summit Business Media (AUS)


Prior to 2002 a tax-free IRA rollover was permitted only into another IRA (except for so-called conduit rollovers, which are not at issue in this article). Pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Pension Protection Act of 2006, effective for years subsequent to 2001, rollovers are permitted from an IRA into a qualified plan, §403(b) annuity, or government §457 Plan to the extent of the otherwise taxable portion of the amount withdrawn from the IRA [I.R.C. §408(d)(3)(A)(ii)].

These provisions obviously liberalize employees' ability to move funds from one kind of tax-favored account to another. Less noticed is the fact that they offer useful planning opportunities.

Mechanics

A participant who wants to roll over IRA funds into an eligible plan should first ascertain that the plan does, in fact, accepts rollovers, since EGTRRA permits but does not require them to do so (see IRS Publication 590, "Individual Retirement Arrangements (IRAs)"). It is a good idea to get a letter from the plan administrator confirming that the plan does accept rollovers.

Once funds are withdrawn from the IRA, the participant has 60 days to roll them over into the eligible plan, as with any other rollover.

Aggregation rule

As noted, I.R.C. §408(d)(3)(A)(ii) provides that "the maximum amount which may be [rolled over from an IRA into an eligible retirement plan] may not exceed the portion of the amount received which is includible in gross income." That is, nondeductible and after-tax contributions and the income derived from them may not be rolled over. To minimize the impact of this limitation, the Code provides a special rule for the characterization of distributions rolled over to an eligible retirement plan: "the portion of [an IRA] distribution rolled over to an eligible retirement plan... shall be treated as from income on the contract (to the extent of the aggregate income on the contract from all individual retirement plans of the distributee)." I.R.C. §408(d)(3)(H)(ii)(II). Thus, IRA distributions rolled over to an eligible retirement plan will be treated as consisting entirely of income (rather than the usual §72 allocation between income and after-tax investment) -- to the extent of the income portion of all of the distributee's IRAs. All are treated as one for this purpose.

Planning consequences

Treatment of rolled-over contributions as taxable

This means that if a participant has multiple IRAs, and wants to effect a rollover to an eligible plan from an IRA that consists of deductible and nondeductible contributions, he or she need not limit the rollover to the taxable contributions in that particular IRA. Suppose that the participant has two IRAs: one of $50,000 (consisting entirely of taxable contributions and income) and one of $150,000 (consisting of $100,000 of deductible contributions and income and $50,000 of nondeductible contributions and income). The participant is not limited to rolling over the $100,000 of taxable contributions in the second IRA. In the aggregate, the two IRAs contain $150,000 in deductible contributions, and that is the amount that can be rolled over.

Suppose that the participant rolls over the second IRA, all 150,000 dollars' worth. Under §408(d)(3)(H)(ii)(II), as stated above, the entire amount is treated as a taxable contribution (as income on the contract), even though that was not its original composition. How is this possible? Section 408(d)(3)(H)(ii)(III) provides that "appropriate adjustments shall be made in applying section 72 to other distributions in such taxable year and subsequent taxable years." In this case, the "appropriate adjustment" is, in effect, to shift the nontaxable portion of the second IRA into the first. Thus, after the rollover, the participant has one IRA remaining of $50,000, treated as nontaxable (investment in the contract).

Treatment of remaining contributions as non-taxable

The effect is almost magical. The participant can now withdraw the remaining $50,000 from the IRA tax free (or taxed only on any income earned between the rollover and the withdrawal). Better still, even if the taxpayer is younger than 59.5, the 10 percent penalty should not apply, because it is 10 percent of that part of a withdrawal that is includible in gross income. [I.R.C. §72(t)(1)]

Consider what would have happened if the participant had withdrawn $50,000 from his or her IRAs (in any combination) without the rollover. The withdrawal would have been taxable as ordinary income to the extent it was deemed to consist of deductible contributions. The rule for allocating the taxable and nontaxable portions of the withdrawal is that of I.R.C. §72(b)(1), under which these amounts are prorated. Thus, since the participant is withdrawing $50,000 from an aggregate of $200,000, or 25 percent, and his nondeductible basis is $50,000, the portion of the withdrawal attributed to basis is 25 percent of $50,000, or $12,500. That number, subtracted from $50,000, leaves a taxable portion of $37,500. And since it is assumed that the participant is younger than 59 1/2 and does not qualify for any of the exemptions to the 10 percent penalty, he will owe an extra $3,750. That's how much a simple rollover can save.

Some other advantages

In addition to enabling a participant to pull out his or her after-tax contributions from an IRA, IRA-to-plan rollovers enable the participant to take advantage of other desirable liquidity features of eligible retirement plans. Specifically, if the plan allows loans, the participant can take one, which is impossible with an IRA, and should the participant be separated from service after age 55, withdrawals from a qualified plan are exempt from the 10 percent penalty. [I.R.C. §72(t)(2)(A)(v)]

Corresponding disadvantages

By the same token, other differences between qualified plan rules and IRA rules might be seen as disadvantages. For example, qualified plans typically offer only a limited choice of investment options compared to IRAs. It is the role of the advisor to help the IRA participant size up all the options before deciding whether and how much to roll over to an eligible retirement plan.

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