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

The Department of Labor’s proposed new fiduciary rules indicate that advice on individual retirement account rollovers from 401(k) plans and other retirement plans is fiduciary advice.

This also covers advice on lump-sum distributions, including whether to use the net unrealized appreciation option when applicable.

As IRA expert Ed Slott recently pointed out, when an investor is seeking advice on what to do with their 401(k) at retirement, understanding the tax consequences of each option is a crucial part of giving advice in their best interest.

Let’s review the tax and other considerations for various IRA rollover and retirement plan distribution options.

Net Unrealized Appreciation (NUA)

If you have clients who hold company stock inside their 401(k), you should look at the net unrealized appreciation option when they leave their employer.

With that option, clients can elect to take a distribution of company shares held inside the 401(k) and then roll over any other assets in the 401(k) to an IRA if they wish. The potential advantage of this strategy is that clients would pay taxes on the cost basis of the shares. The difference between the current market price of the shares and their cost basis is the net unrealized appreciation.

If they hold the shares for at least a year and then sell them, the gains would be taxed at preferential long-term capital gains rates on the difference between the sale price and the cost basis.

This can be a great strategy for clients with company shares in their 401(k), but it is not a no-brainer.

Some cautions when deciding if net unrealized appreciation is appropriate include:

• What is the difference between the current market price of the stock and the cost basis/? If it is relatively small, then using net unrealized appreciation and having clients pay the tax on the cost basis amount may not be advantageous.
• Does it look like the stock will hold its value or appreciate over the next year? Net unrealized appreciation loses its appeal if the stock’s price drops shortly after using this option.
• Will the client meet the requirements to use net unrealized appreciation, including completing the entire distribution of the 401(k) account within one year?
• Stock given the net unrealized appreciation treatment does not qualify for a step-up in basis when the owner dies. Heirs would have to use the original basis, which could lead to a higher tax bill.
• Consider the amount of taxes the client will need to pay on the cost basis of the shares. 

Traditional 401(k) to Traditional IRA Rollover

This type of rollover is common and mostly straightforward. As long as the rollover is done properly, there are no immediate tax implications. Taxes are due when funds are withdrawn, including for required minimum distributions. For many clients this might be the right option when rolling over their 401(k), 403(b) or other retirement plan.

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.