Reverse Rollover: Maximizing Your Retirement

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Updated on Tuesday, January 7, 2020

Rolling over a 401(k) into an IRA is a common process that can help a saver maintain control of their retirement investments even when they part company with the employer providing their 401(k) plan.

Fewer people are familiar with the so-called “reverse rollover,” wherein an IRA account holder rolls over those funds into an employer-sponsored 401(k). Though less common, there are a number of reasons why a saver might want to consider it — as well as several drawbacks. Here’s what you need to know about these accounts and how reverse rollovers between them can work.

Differences between an IRA and a 401(k)

While both of these accounts offer tax-deferral benefits, there are a few important differences to be aware of when choosing either type of account. In addition, it’s important to remember that you may open and contribute to each type of account at the same time, so a rollover may be unnecessary if you are eligible for both account types.

The important differences to remember between IRAs and 401(k) accounts are their contribution limits and income limits:

  • Contribution limits: For 2020, the IRA contribution limit is $6,000 ($7,000 for those over age 50), and the 401(k) limit is $19,500 ($26,000 if over age 50). You can contribute to both a 401(k) and an IRA at the same time, so if you are able to do both, a rollover may not be necessary to increase your total contribution limit.
  • Income limits: IRAs also have a lower compensation limit for receiving the tax-deferral. Savers eligible for an employer-sponsored retirement plan receive a full tax deduction for IRA contributions if their income is less than $64,000 ($103,000 for married couples filing jointly). For 401(k) accounts, the income limit is $285,000 before savers lose the tax-deferral.

Though you can hold both accounts at the same time, you may still be interested in a reverse rollover. There are some important benefits and drawbacks that you should be aware of.

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Reasons to choose a reverse rollover

  • Easier Roth conversion: The Roth IRA is funded with already-taxed dollars, which means it grows tax-free and you can take tax-free distributions in retirement. However, if you are single and make more than $139,000 or married and make more than $206,000, you cannot contribute to a Roth IRA, but you can convert a traditional IRA into a Roth. You’re required to pay taxes on any money in the account that has not already been taxed. So if you have a mix of pre- and post-tax money in your IRA, you can move the pre-tax money into a 401k before doing the Roth conversion. That will leave any post-tax contributions in the IRA available to convert into a Roth IRA without paying any more taxes at the time of conversion.
  • Bankruptcy protection: 401(k) accounts are qualified accounts under the Employee Retirement Income Security Act (ERISA) and not considered to be part of your bankruptcy estate. Until 2005, IRAs had no such protection, but the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA) exempted a portion of IRAs from bankruptcy estates. The IRA amount exempted is currently more than $1 million.
  • Earlier access to funds: Both 401(k) accounts and IRAs have stiff tax penalties for accessing your funds prior to reaching age 59 and a half. However, a 401(k) account holder who leaves their job anytime during or after the year they turn 55 may take distributions from the 401(k) without penalty.
  • Postponed distributions: 401(k) accounts may help postpone required minimum distributions (RMDs), which are the mandated amount you must withdraw from tax-deferred retirement accounts at age 70 and a half. There is no getting around IRA RMDs, but if you are still working at age 70 and a half, you may postpone distributions from your 401(k) until you retire.
  • 401(k) loan options: In a bad financial crunch, you may be able to take a loan from your 401(k) without paying taxes on the withdrawal. You’re required to repay the loan with interest (to yourself) within five years, and if you separate from your employer before you have paid back the loan, it’s considered a distribution, triggering taxes and penalties.

Reverse rollover downsides

  • Fewer investment options: 401(k) plans offer fewer investment options than IRAs, so anyone who wants to hand-pick their investments would be happier sticking with an IRA.
  • Access for higher education and home purchase: While both IRAs and 401(k) accounts allow you to take early, taxable distributions without penalty because of hardship such as disability, medical, or funeral expenses, only IRAs allow such an early, penalty-free (but taxable) distribution for higher education or a first-time home purchase.
  • Indirect rollovers can cost you: With an indirect rollover, your IRA cuts a check for you to deposit into your 401(k). However, your IRA administrator is required to withhold 20% of your distribution for federal taxes. For instance, if you’re rolling over $25,000, you will receive a check for $20,000 and the remaining $5,000 will be sent to the IRS. But you will still be required to deposit the full $25,000 in your 401(k) or face the tax penalty.

How to roll over an IRA into a 401(k)

Start by making sure that your 401(k) plan will accept a rollover from your IRA, since not all plans do. Get your 401(k) set up before you initiate the rollover because you only have 60 days to get the money from one account to the other without a penalty.

Ask your 401(k) plan administrator how to do a direct transfer, where your IRA administrator makes the payment to your 401(k) and you face no tax or penalty. If the money comes to you first in an indirect rollover, 20% of the amount is withheld and you must make up the difference.

Bottom line

Rolling over an IRA into a 401(k) can provide you with a higher contribution and income limit for tax-deferrals, more control over when you take your distributions, an opportunity for an easier Roth conversion, and more financial protection if you face serious money troubles. But it can also limit your investment choices, make it harder to pay for education or a home, and can be costly in the case of an indirect rollover. Savers interested in a rollover IRA to 401(k) must understand all of the ramifications before they commit.

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