On June 5, 2019, the SEC adopted Regulation Best Interest (Reg BI) under the Securities Exchange Act of 1934. Reg BI establishes a “best interest” standard of conduct for broker-dealers and associated persons when they make a recommendation to clients of any securities transaction or investment strategy involving securities.
This includes recommendations of securities account types (e.g., to open an IRA or other brokerage account), as well as recommendations to roll over or transfer assets from one type of account to another (e.g., a workplace retirement plan account to an IRA). As part of this package, the SEC also adopted new rules and forms to require broker-dealers and investment advisors to provide a brief relationship summary, Form CRS, to retail investors. Firms must comply with Reg BI and Form CRS by June 30, 2020.
Factors considered in determining whether a recommendation has taken place include whether the communication “reasonably could be viewed as a ‘call to action.’” A rollover, which is referenced 78 times throughout the Reg, is a call to action.
The application of Reg BI to recommendations of rollovers and withdrawals from retirement accounts is one of the rule’s “most significant enhancements over the status quo,” said Securities and Exchange Commission Chairman Jay Clayton, and these recommendations “should be approached with care.”
Coupled with the highest unemployment rate in U.S. history due to COVID-19, now more than ever it is imperative to understand all options available when rolling over funds from an employer plan to an IRA. While each situation is unique, there are universal considerations advisors must keep in mind when helping clients faced with these important decisions.
Plan Advantages
Losing or changing jobs can be stressful and overwhelming. It may be tempting for some people to simply ignore their retirement savings and leave those dollars in a former employer’s plan. This is not a thoughtful strategy. Funds should only remain in an employer plan if there are compelling reasons to do so.
Factors to consider include:
☑ Federal Creditor Protection: Generally, company plan assets under ERISA receive federal creditor protection. ERISA provides the “gold standard” when it comes to creditor protection outside of bankruptcy.
On the other hand, state law is the only protection offered to IRAs. Since state-level IRA protection varies, it is important to know what safeguards your state offers. If a state provides limited-to-no creditor protection and there are malpractice, divorce, or creditor problems, creditor protection should be considered prior to rolling over to an IRA.
Example 1: Dr. Jonah is facing a malpractice lawsuit. His 401(k) from a previous employer has a value of $2 million. He is considering rolling the entire account to an IRA to purchase investments unavailable in the 401(k) plan.
However, Dr. Jonah was advised to hold off on the rollover until the malpractice case is decided since his state does not offer strong creditor protection. His financial advisor knows that keeping the entire $2,000,000 protected in the plan is more valuable right now to Dr. Jonah than gaining access to a particular investment.
Funds should only remain in a company plan if there are compelling reasons to do so.
☑ Still-Working Exception: Another reason to leave money in a plan is the still-working exception. If an individual subject to required minimum distributions (RMDs) believes her job will be restored after the pandemic, she might want to leave the money in the company plan.
Similarly, an individual who finds a new job might want to roll over the funds to a plan with her new employer. The still-working exception allows individuals to delay RMDs from the company plan where they are still working until after they officially retire or separate from service.
Be aware that the still-working exception is neither a mandatory plan provision nor does it apply to IRAs. As an added consideration, individuals can roll pre-tax IRA funds to a company plan and delay RMDs on those former IRA dollars — assuming the plan allows rollovers from IRAs.
☑ Age 50/55 Exceptions: When a plan participant is age 55 or older in the year he leaves his job he can take withdrawals from that employer plan. The distributions will be subject to tax, but there is no 10% penalty. If he rolls the plan funds to an IRA, any withdrawals before age 59½ will be subject to the 10% early distribution penalty unless an exception applies.
There is an age 50 withdrawal exception for federal, state and local public safety employees. It applies to both defined contribution and defined benefit plans. This group of employees includes law enforcement officers, firefighters, emergency medical service workers, certain customs officials, border protection officers, air traffic controllers, nuclear materials couriers, U.S. Capitol Police, Supreme Court Police, and diplomatic security special agents of the Department of State. Be aware — the age 50/55 exceptions do not apply to IRA distributions.
Tax Breaks to Consider
While traditional IRAs offer a number of benefits that plans do not, before requesting a rollover, individuals should carefully consider all options. Being too quick could mean substantial tax breaks get missed, such as:
☑ Net Unrealized Appreciation (NUA): If a work plan includes highly appreciated company stock, that stock could be withdrawn while the rest of the plan assets could be rolled over to an IRA. If processed properly, the only initial tax owed would be ordinary income tax on the cost basis of the stock when it was acquired within the plan — not the current market value on the day of distribution.
Upon liquidation of the NUA stock at any point in the future (even if immediately after the distribution from the plan), the NUA (appreciation while the stock was in the plan) will receive longterm capital gains treatment. Any appreciation after the original NUA distribution must be held for a year to receive favorable long-term capital gains tax rates.
To qualify for the NUA tax benefit, the original plan distribution must be a lump-sum distribution, meaning all plan assets must be distributed in one calendar year. The company stock gets transferred in-kind to a nonqualified brokerage account, and the remaining dollars go to an IRA.
The distribution can only occur after any one of these four triggering events: reaching age 59½; separation from service (not for self-employed); disability (only for self-employed); or death. A good custodian and/ or plan administrator can offer invaluable assistance with an NUA transaction.
Be careful not to jump the gun. If company stock is rolled over to an IRA, there is no going back. A rollover is irrevocable and the NUA opportunity will be lost forever.
Example 2: Nora, age 62, recently retired from ABC Bank. She has $800,000 in her 401(k), which consists of $500,000 in ABC Bank stock and $300,000 in cash. The cost basis of her bank stock is only $100,000. Nora has not taken any distributions from her plan and has met two triggering events (age 59½ and separation from service).
Nora executes an NUA transaction in one calendar year: the $300,000 in cash is rolled over to her IRA, and the $500,000 in ABC Bank stock is distributed to her nonqualified brokerage account.
Nora will only owe ordinary income tax on the $100,000 cost basis of the stock. She will pay long-term capital gains on the $400,000 of NUA whenever it is sold. Any additional gains on the ABC Bank stock above the $500,000 day-of-distribution value will need to be held for one year to receive long term capital gains treatment.
☑ Roth Conversions: Another option when moving money from a work plan to an IRA is a Roth conversion. For those who lost their job this year and anticipate decreased income, a Roth conversion could be in the cards.
Yes, Roth conversions are usually taxable, but a reduction in annual income might drop them into a lower tax bracket, thereby potentially reducing the tax hit. For those with after-tax funds in their employer plan, this may be the time to convert those dollars to a Roth IRA with no tax bill.
How so? When funds are distributed from a plan, the administrator can separate the pretax and after-tax portions. The pretax monies can be directly rolled over to a traditional IRA, and the after-tax portion can be converted to a Roth IRA, tax-free.
The option to split the pre-tax and after-tax portions is only available when a distribution comes from a plan. If all funds are rolled over to a traditional IRA, this break is lost. The plan dollars are now considered to be IRA funds and are subject to the pro-rata formula.
The plan dollars are now considered to be IRA funds and are subject to the pro-rata formula.
Example 3: Al left his former employer and would like to consolidate his 401(k) plan with his IRAs. His 401(k) consists of $300,000 in pre-tax dollars, $100,000 in Roth, and $50,000 in after-tax (non-Roth) dollars. Al can roll the pre-tax monies to a traditional IRA and the 401(k) Roth dollars to a Roth IRA. The after-tax dollars can go to either IRA.
If he rolls the $50,000 in after-tax dollars to his traditional IRA, he will now have basis that will be subject to the pro-rata rule, should he wish to do a Roth conversion in the future. Al avoids this headache by rolling his after-tax funds directly from the plan to the Roth IRA.
IRA Rollover Advantages
There are definitive advantages of rolling money to an IRA vs. leaving it in an employer plan, such as:
☑ Estate Planning: Since IRAs can more easily be coordinated with an overall estate plan, this makes for another consideration whether to roll over or not. For example, IRAs offer the option of splitting accounts while the owner is still alive and naming several primary and contingent beneficiaries. IRA owners can name anyone they wish as their IRA beneficiary.
Funds in some company retirement plans are subject to a federal law that requires participants to name their spouse as beneficiary unless the spouse signs a waiver. The IRA rollover makes the estate plan more flexible. This flexibility within an IRA allows owners to make changes quicker and without the administrative hurdles or delays that plans can impose.
☑ Investment Options: IRA owners have more investment options to choose from compared to a limited number of investments typically offered by company plans.
☑ Consolidation and Control: Rolling over old work plans into an IRA is a great way to consolidate retirement funds. Consolidation will help participants stay in control by minimizing paperwork and will streamline withdrawal options. RMDs can be aggregated among IRAs so individuals will no longer have to worry about required distributions from both their company plan(s) and IRAs.
☑ No Withdrawal Restrictions: Work plans have strict rules as to when a participant can access an account and what dollars are available. Even in an emergency, loans and/or hardship withdrawals from a plan may not be allowed. IRAs carry no such restrictions. IRA owners, regardless of age, have full access to their IRA account. Penalties may apply to those under age 59½.
☑ Qualified Charitable Distributions (QCDs): For the charitably inclined, a QCD can exclude an IRA withdrawal from income and annually direct up to $100,000 to qualified charities. Since QCDs are available from IRAs only, individuals that have money in a work plan will first need to roll the money to an IRA.
Copyright © 2020, Ed Slott and Company, LLC Reprinted from Ed Slott's IRA Advisor, July 2020, with permission. Regulation Best Interest and Rollover Considerations: Employer Plan to IRA Ed Slott and Company, LLC takes no responsibility for the current accuracy of this article.