3713.05 / What should taxpayers consider when deciding whether to execute a “reverse” rollover from an IRA into a 401(k)?

Nearly every taxpayer is familiar with the concept of rolling funds from an employer-sponsored 401(k) into an IRA. The strategy is a common one for taxpayers once they are no longer employed by the company sponsoring the 401(k)—and can also give the taxpayer more control over the management of their retirement funds. On the other hand, rollovers from IRAs into company-sponsored 401(k)s are relatively rare. There are situations in which executing a “reverse rollover” from an IRA into a 401(k) can be advantageous, especially for those who are interested in minimizing their RMD obligations upon hitting their required beginning date.

Taxpayers should first understand that a 401(k) plan is under no obligation to accept rollover contributions. While all 401(k)s must allow taxpayers to transfer funds out of the 401(k) into an IRA, the reverse is not true. So, before considering the reverse rollover strategy, the taxpayer should check with their plan sponsor to determine whether rollovers are accepted in the first place.

Further, while taxpayers may be entitled to roll pre-tax IRA dollars into a 401(k), the IRS does not allow taxpayers to roll nondeductible or Roth IRA contributions back into a company-sponsored 401(k). In situations where the IRA contains both deductible and nondeductible contributions, the deductible contributions can be segregated and rolled over into the 401(k).

While the benefits of a traditional 401(k)-to-IRA rollover are fairly clear, the benefits of executing a reverse rollover are less obvious. For the right taxpayer, the reverse rollover can allow the taxpayer to avoid taking required minimum distributions (RMDs) once the client reaches their required beginning age (which is currently age 73).

Under the “still working” exception for 401(k)s, the taxpayer is not required to begin taking RMDs even after reaching the required beginning date if the taxpayer continues to work for the employer that sponsors the plan. Note, however, that the taxpayer can only take advantage of the still working exception if the client does not own more than 5 percent of the company and the plan allows delayed RMDs. The rules governing IRAs do not allow for delayed RMDs even if the taxpayer continues to work after reaching their required beginning date.

An IRA-to-401(k) rollover can also help minimize tax liability if the taxpayer decides to execute a Roth conversion. Under the “pro rata rule,” the taxpayer must consider both deductible and nondeductible IRA contributions that exist as of December 31 of the year of conversion when funding a backdoor Roth using the conversion strategy.

If the IRA contains pre-tax dollars and after-tax dollars, at least a portion of the amount converted will be taxed in the year of conversion. However, if the taxpayer rolls all pre-tax funds into the 401(k) during the year of conversion, the Roth conversion will be nontaxable (similarly, if the taxpayer rolls a portion of the pre-tax dollars into the 401(k), a smaller portion of the amount converted will be taxable).

Taxpayers who are interested in taking a loan from their retirement plan may also be interested in the reverse rollover option. 401(k)s can allow participants to take loans from the plan, while IRAs do not offer a similar option (however, it is important to check with the specific 401(k) because 401(k)s are not required to offer plan loans).

As with any strategy, there are potential downsides that the taxpayer should consider before executing the reverse rollover. Both IRAs and 401(k)s impose a 10 percent penalty for early withdrawals. Each type of plan allows for exceptions that can allow the taxpayer to avoid the penalty in certain situations.

Those exceptions vary based on whether the account is a 401(k) or an IRA, so taxpayers should carefully examine the various exceptions to determine whether they may need to take advantage of a particular exception in the future. For example, taxpayers can avoid the early withdrawal penalty for IRA distributions used to buy a first home, but the first-time homebuyer exception is not available for 401(k) early withdrawals.

Taxpayers should also consider the various investment options available under each type of plan. IRAs tend to allow for a wider variety of investments, especially if the taxpayer is interested in nontraditional retirement investments, such as cryptocurrency and real estate. 401(k) investments are limited by the plan itself and tend to contain more traditional investment classes.

401(k)s also offer stronger creditor protection (protection offered for IRA funds can vary from state to state).