Let It Roll, Baby, Roll

The large print giveth, but the small print taketh away.
—Tom Waits, singer and songwriter

We have always advised clients that they should roll over their employer-sponsored retirement plan, such as a 401(k) or 403(b), to an IRA when they retire or leave an employer.

Rollovers make sense for many reasons. Primarily, you gain greater control over your retirement savings through a rollover. No longer are you limited to the investment choices offered by your employer’s retirement plan. Often, you can find the same investments, but with lower expenses.

Rollovers have another benefit that (hopefully) won’t come into effect for many years. When the owner of the assets in an IRA dies, his or her non-spouse beneficiaries have much more flexibility in withdrawing the assets from that IRA. The financial advantage of an IRA can be substantial.

In most employer plans, non-spouse beneficiaries (children, siblings, and unmarried partners) must withdraw their inheritance from an employer plan within five years. Often, this results in a large tax bite because those withdrawals are taxed when withdrawn, and a large withdrawal can shift an heir into a higher tax bracket.

However, if the non-spouse beneficiary inherits funds from an IRA, he or she can “stretch” withdrawals from the IRA over his or her own life expectancy. Properly managed, these withdrawals can keep an heir in a lower tax bracket. Also, it will allow the assets in the IRA to continue to grow on a tax-deferred basis for many more years.

In May 2007, Business Week magazine illustrated the problem with the tale of Ian and Brody Bents (“A Costly Glitch For 401(k) Heirs”), who inherited their father’s 401(k). Ian Bents, age 26, is inheriting assets from his deceased father’s 401(k), which was not rolled over. He expects to pay combined federal and state income taxes of 41% on his share of his father’s IRA in 2007.

In contrast, if Ian had inherited those same funds from an IRA, he would have been able to spread out withdrawals and taxes over 57 years. Those additional years of tax-deferred growth would have added up to hundreds of thousands of dollars. Note that he would not be required to spread them out for so many decades; he would have the choice, based on whatever financial obligations and opportunities he encountered.

The Pension Protection Act (PPA) of 2006 was supposed to fix this problem. The intent of PPA 2006 was to enable non-spouse beneficiaries to transfer inherited employer plan balances to IRAs and to stretch the distributions over their lifetimes. However, the IRS ruled that employers can choose whether to amend their plans to allow non-spouse beneficiaries to make withdrawals over their life expectancies. Many employers have chosen not to change their plans.

Unfortunately, it was widely reported in the press that employers must allow non-spouse beneficiaries the “stretch” option. It’s not true. If you read the fine print, employers merely have the option to offer the stretch.

And there’s more fine print. Even if the employer allows the stretch, the IRS has ruled that the beneficiary must transfer his or her inheritances from the employer plan to the IRA by the last day of the year after the year in which the account owner dies. If heirs do not meet the deadline, they can still move their account balances, but they have to make withdrawals as specified in the employer plans (typically, five years).

The bottom line is that the rollover IRA remains a much better solution when you retire or leave your employer for any other reason.