Understanding Reverse 401(k) Rollovers: A Strategic Tax Move for Pre-Retirees

When the topic of rollovers in retirement planning arises, the focus often falls on transferring funds from an employer-sponsored 401(k) to an Individual Retirement Account (IRA). This practice is popular for its simplicity in consolidating retirement savings and cultivating a tax-efficient retirement.

However, within the broader scope of tax planning strategies lies a lesser-known option: the reverse 401(k) rollover. This alternative approach inverts the standard rollover process, offering unique benefits that can be particularly valuable for pre-retirees.

To use this strategy to your advantage, it’s crucial to understand its nuances and how it aligns with your broader financial goals. Here’s an in-depth look at why a reverse 401(k) rollover might be a strategic move to consider as you navigate the road to retirement.

What Is a Reverse 401(k) Rollover?

First, it’s important to note that a reverse 401(k) rollover may not be universally available, as not all 401(k) plans permit such transfers. Be sure to check with your plan administrator to determine whether it allows incoming rollovers.

For those with qualifying plans, a reverse 401(k) rollover involves transferring funds from an Individual Retirement Account (IRA) into a 401(k) plan. While standard practice is to roll 401(k) assets into an IRA, the reversal of this strategy offers distinct financial benefits for savvy retirement planners.

Why Consider a Reverse Rollover?

There are several reasons to consider a reverse 401(k) rollover, including:

• Consolidating retirement funds for simplicity.
• Taking advantage of more favorable investment choices or lower fees in a 401(k) plan.
• Delaying required minimum distributions (RMDs)—an option available within a current employer’s 401(k) plan but not within a traditional IRA.

Yet, one of the most significant advantages of a reverse 401(k) rollover is that it can amplify the tax benefits of a backdoor Roth strategy.

A backdoor Roth, also known as a Roth conversion, involves converting funds from a tax-deferred account like a traditional IRA to a Roth IRA. It shifts your tax liability to the present, so you can enjoy tax-free distributions and other financial benefits in retirement (provided you meet certain requirements).

Since there are income limits for contributing to a Roth account, a backdoor Roth can be a boon for high earners who want to enjoy the advantages of a Roth IRA but can’t contribute to one directly. When combined with a reverse rollover, the associated financial benefits of a Roth conversion can be sizeable.

Combining a Reverse Rollover with a Roth Conversion

The IRS treats all IRAs as one for the purposes of a Roth conversion, preventing individuals from just converting their after-tax contributions to avoid taxes. Therefore, if you have both pre-tax and after-tax dollars in any of your IRA accounts, it’s important to understand how the pro-rata rule can influence the tax impact of a backdoor Roth.

Essentially, the pro-rata rule determines how much of a Roth conversion is taxable in proportion to the pre-tax and after-tax funds across a taxpayer’s IRA accounts. For example, suppose the funds in your IRAs total $100,000—$20,000 of which represents after-tax contributions—and you decide to convert $10,000 to a Roth IRA.

Using the pro rata rule, only $2,000 of the $10,000 conversion would be tax-free: ($20,000 after-tax / $100,000 total balance) x ($10,000 conversion). The remaining $8,000 would be subject to ordinary income taxes in the same tax year you make the conversion.

Because of the pro-rata rule, a Roth conversion can have significant tax implications if you have a mix of pre-tax and after-tax funds. One way to manage the tax impact is to move your pre-tax funds into a 401(k) plan through a reverse rollover (if the plan allows it).

By moving pre-tax IRA funds to a 401(k), you effectively reduce or eliminate the pre-tax balance in your IRAs, minimizing the taxable portion of a Roth conversion. This maneuver can be particularly valuable for pre-retirees looking to shift their retirement savings to a Roth IRA for its tax-free growth and distributions.

However, keep in mind that the timing is crucial. Ideally, the reverse 401(k) rollover should occur in the same tax year as the Roth conversion to maximize the benefits.

Maximizing the Benefits of a Reverse 401(k) Rollover

For high earners preparing for retirement, a reverse 401(k) rollover can be a strategic ally to a backdoor Roth. By transferring pre-tax IRA funds into a 401(k), you can minimize the immediate tax impact of a Roth conversion and capitalize on these benefits during retirement.

For personalized guidance on how a reverse 401(k) rollover and backdoor Roth can enhance your retirement plan, we encourage you to reach out to a CornerCap wealth advisor. Our team of experts can help determine which strategies are in alignment with your objectives and long-term goals, setting the stage for a more prosperous and tax-efficient retirement.