IRA Rollovers and Taxes: What to Know as New DOL Fiduciary Rule Looms

There are some cautions and considerations in determining if a rollover to a traditional IRA is the right course of action:

• Does the client have issues that require the extra creditor protection of a 401(k)? If so, then perhaps leaving the money in a former employer's 401(k) or rolling the money to a new employer's 401(k) might be a better option.
• If clients are changing jobs and plan to keep working once they reach the age where RMDs commence, it may make sense to roll their 401(k) to their new employer's plan if it offers the option to allow employees to defer RMDs on money in the plan while still working.
• Are the funds offered in their former employer's plan, or the plan offered by their new employer if applicable, low-cost institutional quality funds? Do these investments constitute a better option than what might be available via the IRA to be used for the rollover?
• Is the client eligible to take advantage of the rule of 55 allowing for penalty-free distributions before age 59 1/2?

The Rule of 55

The rule of 55 as it pertains to 401(k)s and some other employer plans says that those leaving their employer due to a job loss, quitting their job or other reasons can begin taking withdrawals from their plan account at age 55 with no early withdrawal penalty. 

This can be a good option for clients in some cases, especially if their income is lower than normal at that point or they are moving into some type of early retirement. A number of rules must be adhered to, but if the client leaves a job at age 55 or later (age 50 for first responders and others), this is an option that should be considered as an alternative to rolling a 401(k) to an IRA.

Lump-Sum Options

In some cases, taking a partial or total lump-sum distribution from a client's 401(k) or other retirement plan can make sense.

If the client has a Roth 401(k) or 403(b), has met the five-year rule requirement and is at least age 59 1/2, taking a tax-free lump-sum distribution can make a lot of sense. This money can be used by the client instead of tapping other accounts and perhaps incurring a tax hit.

In the case of a pension plan, clients may be offered the opportunity to take a lump-sum distribution. This may be as a sweetener to encourage early retirement or by some private-sector plans looking to reduce future liabilities and ultimately terminate the plan. In many cases, a rollover to an IRA is the best option. This allows the client to keep this money tax deferred.

But once again this is not the right answer in all cases. If the client's income is lower than normal, it can make sense to take some or all of the distribution on a taxable basis and pay the taxes. Or it can make sense to roll some or all of the lump sum into an annuity to generate the monthly income the client would have had with a pension.

Bottom Line: The DOL Fiduciary Rule and Rollovers

For many advisors, the proposed fiduciary rules won't change anything. They were already analyzing the best options for clients surrounding IRA rollovers and retirement plan distributions. The new rules could turn this process into a requirement. Advisors will need to document their analysis surrounding their IRA rollover recommendations for each affected client.

Advisors will need to examine the tax implications of a rollover not only in the current year but also down the road. For example, a rollover to a traditional IRA might shield the client from any taxes in the current year, but the added rollover money could affect taxes on RMDs in the future.