Home Financial Planning Steven Merrell, Financial planning: Get tax-smart with reverse rollovers – Monterey County Herald

Steven Merrell, Financial planning: Get tax-smart with reverse rollovers – Monterey County Herald

8 min read

A lot of people have retirement accounts. Some people use their retirement accounts to build tidy little nest eggs over the course of their careers. They brave the perils of the markets and learn the discipline necessary for investment success. If you are one of those intrepid souls, I congratulate you. Here are some ideas that might help your retirement accounts work even harder for you.

You probably already know that the IRS requires you to begin taking minimum distributions from traditional IRAs and IRA-based plans like SEPs in the year you turn 70½.  A similar rule applies if you participate in an employer sponsored retirement plan like a 401(k), 403(b) or 457(b) plan. The deadline to take your first RMD is April 1 of the year after you turn 70½. All subsequent distributions must be taken by Dec. 31 of the year for which the RMD is due.

Did you also know that the IRS allows you to defer your RMDs from your company’s 401(k) plan if you are still working when you turn 70½?  The only limitation on this exception is if you own more than 5 percent of sponsoring company. In that case, you must take your RMD at 70½, though you can still contribute (and receive your company’s matching contributions) until you retire.

Note that this deferral is good only for RMDs from your current employer’s retirement plan. The IRS still requires you to take distributions from IRAs, SEP IRAs, SIMPLE IRAs and any 401(k) accounts still open at previous employers. However, you may be able to defer RMDs from those accounts if you do something called a reverse IRA to 401(k) rollover.

A regular rollover is when you roll 401(k) money into an IRA. A reverse rollover is just the opposite – rolling IRA money into a 401(k) plan. Not every plan permits reverse rollovers, but more and more do. If yours does and you are still working at 70½, simply roll all your outstanding IRA accounts into your current company’s 401(k) plan and defer all of your RMDs until you retire.

The reverse rollover can also be used in other tax-smart ways. For example, they can help you do something called a backdoor Roth IRA conversion.

Let’s suppose you want to contribute money to a Roth IRA, but your income is above the Roth limit. A backdoor conversion gets you around this limit. With a backdoor conversion you make a non-tax deductible contribution to a traditional IRA and covert it into a Roth IRA. Because the money you contributed was already taxed, no tax is due on the conversion. However, you have to prepare for the conversion by first eliminating all pre-tax money from your IRAs.

Here is why: when you do a Roth IRA conversion, the IRS assumes that you convert a proportional amount of every IRA you own. If you have some IRAs that were funded with pre-tax dollars, some of your conversion will be taxable. An example will help illustrate how it works.

Suppose you have two traditional IRAs with assets totaling $50,000. In the first IRA you have $5,000 of after-tax money which you have contributed in order to do a backdoor Roth conversion. In the second IRA, you have $45,000 that was funded with pre-tax dollars. If you were to convert the $5,000 IRA while the $45,000 was still in the other IRA, the IRS would assume that 1/10 of your conversion came from the after-tax IRA and 9/10 came from the pre-tax IRA. In other words, the IRS would consider $4,500 of your conversion to be taxable.

You can avoid this problem by using a reverse rollover to remove the pre-tax IRA before doing the backdoor conversion. Once the pre-tax IRA is safely rolled into your 401(k) plan, you can do the Roth conversion confident that 100% of your after-tax money ends up in the Roth IRA and you pay no tax.

Steven C. Merrell is an investment adviser and partner at Monterey Private Wealth Inc., in Monterey. Send questions concerning investing, taxes, retirement or estate planning to Steve Merrell, 2340 Garden Road Suite 202, Monterey 93940 or steve@montereypw.com.

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