If you have a 401(k), you may know you can transfer—or "roll over"—the funds into an IRA. But did you know that rollovers work both ways?
Enter the reverse rollover, which lets you move funds from an existing IRA into your current 401(k), assuming your plan allows it.
Here are two scenarios where a reverse rollover might make sense:
1. You want to delay your required minimum distributions (RMDs)
If you're still working when you reach age 73 (75 for those born after 1959) and you own 5% or less of your company's stock, your employer may allow you to delay taking RMDs from your 401(k) until you retire.
Unfortunately, you'll still need to take RMDs from your IRAs. However, rolling an IRA into your 401(k) would allow you to delay those RMDs, too. This could be ideal for workers whose RMDs would push them into a higher tax bracket.
2. You want to perform a tax-free Roth IRA conversion
If your traditional IRA contains both pretax and after-tax contributions, a Roth conversion will be taxable in proportion to the pretax value of the account (known as the pro rata rule).
For example, let's say you have a $400,000 IRA that's 75% pre-tax contributions ($300,000) and 25% after-tax contributions ($100,000). If you converted $100,000 to a Roth IRA, you'd owe tax on 75% of the converted amount. On the other hand, rolling all $300,000 in pretax contributions into your employer's 401(k) could allow you to convert the remaining $100,000 to a Roth IRA tax-free.
Calculating your pro rata percentages can be complex, so it's best to consult with your plan sponsor and a tax advisor before moving forward with a reverse rollover and Roth conversion to avoid any unpleasant tax surprises.
Proceed with caution
That said, reverse rollovers do have some drawbacks. For one, your money can be locked up in the 401(k) until you retire, excepting loans and financial hardship, and the funds become subject to plan rules.
IRAs, on the other hand, permit withdrawals at any time—though you may owe a 10% early-withdrawal penalty if you're younger than age 59½ and don't meet one of the exemptions, such as using the money for a first-time home purchase or for educational expenses. Plus, IRAs generally have more investment choices than 401(k)s, so bear that in mind when weighing your options.
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This material is intended for general informational and educational purposes only. The investment strategies mentioned may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions.
This information is not a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager, Estate Attorney) to help answer questions about specific situations or needs prior to taking any action based upon this information.
Investing involves risk, including loss of principal.
Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59½ are subject to an early withdrawal penalty.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.