Combining Your Plan Assets? Not So Fast!

By Denise Appleby AAA

Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), individuals were allowed to roll over an IRA to a qualified-plan account, only if those IRA assets originated from a qualified plan and were maintained in a conduit IRA. This helped retirement account owners ensure that their qualified-plan assets retained certain tax benefits. EGTRRA, which became effective for tax years beginning 2002, changed the rules to allow retirement account owners to move assets between regular (non-conduit) Traditional IRAs, 403(b) accounts, 457(b) accounts and qualified plans. Many retirement account owners are now considering the allowable benefits of combining their retirement accounts. (To learn more about the rules of converting an IRA annuity to a Roth, see Converting An IRA Annuity To A Roth: Know The Rules)

TUTORIAL: Retirement Plans

Combining your retirement plan assets is great for many reasons: it reduces your fees and your account statements by reducing the number of accounts you must maintain. However, before you combine your qualified-plan assets with your other retirement plan account balances, ask yourself two questions:

  1. Does my retirement account include qualified-plan balances that accrued before 1974?
  2. Was I born before 1936?

If the answer is no to both questions, then there is no tax benefit to keeping the assets separate. If the answer to any of these questions is yes, then you may lose tax benefits by combining your retirement plan account balances. Here's why: certain plan balances are eligible for special tax treatment, whereby the retirement account owner pays less than his or her ordinary income tax rate. These particular plan balances are ones that accrued before 1974 or belong to individuals who were born before 1936. (Is your child ready to file their first tax return? Learn how to do it here, How To File Your Child's First Income Tax Return)

Plan Balances Accrued Before 1974
If your qualified-plan account includes balances that accrued prior to 1974, and you take a lump-sum distribution from the plan, you may be able to have that pre-1974 amount taxed as a capital gain; this means that the distribution will be taxed at a flat rate of 20% instead of your ordinary tax rate, which could be more than 38%.

Note: Individuals with a small dollar amount of compensation, may have a tax rate lower than 20%. Check with your tax professional to determine your tax rate, and how you could be affected by these tax benefits

If you were born before 1936, you are allowed to treat the lump-sum distributions, from a qualified plan, as though they were received over a 10-year period. This is referred to as "10-year forward averaging," and results in the distribution being taxed at a lower rate.

Lump-Sum Distribution Defined
To be eligible for the special tax treatments mentioned above, your qualified-plan distribution must be a lump-sum distribution. In general, distributions from qualified plans are treated as lump-sum, if the following requirements are met:

  • The total plan balance is distributed over the same tax year.
  • The distribution is made as a result of any of the following:
    • The employee attains age 59.5.
    • The employee dies (applicable to beneficiaries).
    • The employee separates from service (not applicable to self-employed individuals - but applies to their common-law employees).
    • The employee becomes disabled (applicable only to self-employed individuals).
  • The distribution occurs after five years of participation. This requirement is waved for beneficiaries.

Conduit IRAs
As mentioned earlier, the provisions of EGTRRA allow you to combine your regular IRA, 457(b), 403(b) and qualified-plan assets. If, however, you want to preserve the capital gain and 10-year income averaging treatment of qualified-plan assets, you should retain the assets in either a qualified plan or a conduit IRA. The intention behind a conduit IRA, an IRA that temporarily holds assets distributed from a qualified plan, is to roll the assets to another qualified plan in the future. Assets maintained in a conduit IRA can be to be rolled back to a qualified plan, and still be eligible for the special tax treatments. Should any other assets be commingled in the conduit IRA, it loses its conduit status, and the assets are no longer eligible for the special tax treatments. (To learn more about IRAs, see Tips On How To Use IRAs To Boost Retirement Savings)

Distributions Ineligible for These Special Tax Treatment
Not all distributions from retirement plans are eligible for the capital-gains treatment, or the 10-year income averaging. Here is a list of ineligible distributions:

  • Any distribution of which a portion is rolled to an IRA, qualified plan or other eligible retirement plan.
  • Any distribution by an individual who had already benefited from an income-averaging option, such as 10-year income averaging or five-year income averaging after 1986.
    Note: The five-year income averaging is repealed taxable years beginning on or after Jan. 1, 2000.
  • U.S. retirement-plan bonds distributed with a lump sum.
  • Any distribution made during the first five tax years that the individual was in the plan, unless the distribution occurs as a result of the death of the plan participant.
  • The current actuarial value of any annuity contract included in the lump sum.
  • A distribution from an IRA.
  • A distribution from a tax-sheltered annuity (section 403(b) plan).
  • A distribution of the redemption proceeds of bonds rolled over tax free from a qualified bond purchase plan to a qualified pension plan, etc.
  • A distribution from a qualified plan if the participant, or surviving spouse, previously received an eligible distribution from the same plan that was rolled over, tax free, to another qualified plan or an IRA. Or, a distribution from a qualified plan that was, for the lump-sum distribution rules, combined with an eligible distribution from another plan of the employer.
  • A distribution from a qualified plan that after 2001 received a rollover from an IRA (other than a conduit IRA), a governmental section 457 plan, or a section 403(b) tax-sheltered annuity on behalf of the plan participant.
  • A distribution from a qualified plan that received a rollover after 2001 from another qualified plan on behalf of that plan participant\'s surviving spouse.
  • A corrective distribution of excess deferrals, excess contributions, excess aggregate contributions or excess annual additions.
  • A lump-sum credit or payment from the Federal Civil Service Retirement System (or the Federal Employees\' Retirement System).

Conclusion
It may make sense to combine your retirement assets because it reduces the number of accounts you must maintain, making it more convenient and cheaper to control your accounts. There is, however, an important tax consideration: if your retirement account includes qualified-plan balances that accrued before 1974, or if you were born before 1936, you may lose tax benefits by combining assets. And, if you do decide to combine, remember that your qualified-plan distribution must be a lump-sum distribution for you to receive tax benefits. Beyond what we've covered here, there any many other issues to consider regarding the tax treatment of your retirement plan distributions. As for any issue relating to retirement plans, we strongly recommend that you seek competent tax advice before making any decisions.

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