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What is a Rollover IRA? (Rollover IRA vs. Traditional IRA)

A reader writes in, asking:

“At my primary brokerage firm I have two IRAs: a traditional IRA and a rollover IRA that holds assets that came from my prior employer’s 401-k plan. What is the difference between the two?”

“Rollover IRA” is just a subcategory of “traditional IRA.” In other words, a rollover IRA is a traditional IRA. Specifically, rollover IRAs are traditional IRAs that contain nothing but assets that came from an employer-sponsored plan.

Because a rollover IRA is a traditional IRA, it gets all the same tax treatment as a normal traditional IRA. That is, distributions from the account are generally taxable; you can do a Roth conversion of the assets in the account; it’s treated the same way with regard to aggregation rules as other traditional IRAs; and so on.

Rollover IRAs are designated as such (rather than just being called regular traditional IRAs) for two reasons.

Reason #1: some employer plans only accept rollovers from an IRA when the IRA contains only assets from another employer-sponsored plan. So keeping those assets separate in their own IRA (rather than combining them with other assets in a traditional IRA) could preserve your ability to roll those assets into a different employer plan at a later date. But fewer and fewer employer plans have this policy every year, so this distinction is becoming less relevant.

Reason #2: assets in an employer-sponsored plan have unlimited creditor protection in bankruptcy under federal law. In contrast, IRA assets are only protected up to a certain limit ($1,362,800 as of 2020). If assets from an employer-sponsored plan are rolled into an IRA and kept separate (i.e., kept in a separate “rollover IRA”), they continue to receive that unlimited protection. If the assets get commingled with other assets in a traditional IRA, then they might lose that unlimited protection and “only” be protected up to the $1,362,800 limit.

That said, some people make the case that if you have good records and could prove that the assets in question came from an employer plan, you would still have unlimited protection for those assets. Also, many states provide additional protection to IRA assets beyond what federal law provides. And of course most people’s IRA assets are never going to exceed the federal protection limit anyway.

To summarize, a rollover IRA is a traditional IRA and is taxed as such, but there are two reasons for keeping rollover IRA assets separate from other traditional IRA assets. It may well be the case, however, that neither of those two reasons is particularly applicable to your own circumstances.

When Are IRAs Aggregated?

A reader writes in, asking:

“I have read that your traditional IRAs are all considered one IRA as far as the IRS is concerned. But I recently found another article that explicitly indicated otherwise. Maybe it depends on circumstances? Could you elaborate on this in an article?”

The issue is not so much that it depends on circumstances, but rather that IRAs are aggregated for some purposes and not for other purposes.

Traditional IRAs Aggregated for RMDs

For RMD purposes, all of your traditional IRAs will be treated as if they are one collective traditional IRA. Specifically, each traditional IRA will have its RMD calculated separately, but then you can total up all your necessary traditional IRA RMDs for the year and take that total amount out of any one traditional IRA or any combination of traditional IRAs.

Note that SEP IRAs and SIMPLE IRAs count as traditional IRAs here, so they are aggregated as well.

Employer-sponsored plans are not aggregated with your IRAs though (nor are they aggregated with each other). For example, a distribution from your 401(k) will not count toward satisfying your traditional IRA RMD for the year.

Traditional IRAs Aggregated for Distribution/Conversion Taxability

Similarly, when you take a distribution from a traditional IRA — or do a Roth conversion from a traditional IRA — whether or not it is taxable will depend on an aggregated calculation.

Example: Joan has made $20,000 of nondeductible contributions to her traditional IRA at Vanguard. During 2020, Joan makes a $40,000 Roth conversion from that IRA. At the end of the year, the balance in Joan’s Vanguard traditional IRA is $100,000. She also has a traditional IRA at Schwab with a year-end balance of $60,000. She has taken no other distributions (or done any other conversions) from these IRAs.

The nontaxable portion of Joan’s conversion is calculated as her basis in traditional IRAs (i.e., the amount of nondeductible contributions she has made), divided by the sum of her year-end balances and distributions or conversions from traditional IRAs over the course of the year. (And again, we’re counting all of her traditional IRAs here.)

Joan’s basis is $20,000. The sum of her year-end traditional IRA balances is $160,000. And the sum of her conversions and other distributions from traditional IRAs for the year is $40,000. So the nontaxable portion of Joan’s conversion is calculated as: $20,000 / ($160,000 + $40,000) = 10%. In other words, 90% of Joan’s conversion will be taxable.

IRAs Not Aggregated for “SEPP” Distributions

IRAs are not aggregated for the “series of substantially equal periodic payments” rule, sometimes referred to as 72(t). For that purpose, each traditional IRA is treated as its own separate account.

Aggregation for Roth IRA 5-Year Rule

With regard to the 5-year rule for distributions of earnings from Roth IRAs, once you have satisfied the 5-year rule for one Roth IRA, you have satisfied it for all Roth IRAs.

Inherited IRAs Not Aggregated

Inherited IRAs are not aggregated with other IRAs for RMD purposes, nor are inherited IRAs aggregated with other IRAs for the purpose of calculating what portion of a distribution (or conversion) is taxable.

Inherited IRAs can be aggregated with each other for RMD purposes if the inherited IRAs in question a) were originally owned by the same person and b) are being distributed over the same period (i.e., if the inherited IRAs are being distributed over somebody’s life expectancy, it must be the same life expectancy that is being used for each inherited IRA if you want to aggregate them with each other for RMD purposes).

Inherited IRA Rules (Updated for 2020 to Reflect SECURE Act and CARES Act)

As a result of the SECURE Act that was passed in late 2019, there are now essentially two sets of rules for inherited IRAs. Which rules to use depends on a) when the original account owner died and b) who is listed as the beneficiary of the account.

Also, as a result of the CARES Act that was passed in March 2020, there are no required distributions for 2020 from IRAs — whether inherited or not.

Death in 2020 or Later

If the IRA owner dies in 2020 or later, we first have to determine whether the beneficiary is an “eligible beneficiary.”

Eligible beneficiaries include:

  • the surviving spouse of the original account owner,
  • a minor child of the original account owner,
  • anybody who is disabled or chronically-ill (per the definition found in IRC 7702B(c)(2)), or
  • any designated beneficiary who is not more than 10 years younger than the original account owner.

If the beneficiary is an eligible beneficiary, then the old rules apply (see below).

If the beneficiary is not an eligible beneficiary, the new rule applies. And the new rule simply says that the account must be completely distributed within 10 years of the original owner’s death. The distributions do not, however, have to occur evenly over those 10 years. (For instance, if you wanted to do so, you could take no distributions for the first 9 years, then distribute everything in year 10.)

Deaths in 2019 or Earlier, As Well as Eligible Beneficiaries

The “old rules” discussed in the remainder of this article apply in situations in which either:

  • The IRA owner died in 2019 or earlier, or
  • The beneficiary is an “eligible beneficiary” as described above, and therefore able to use the (more favorable) old rules.

Under the “old rules,” there are still actually two sets of rules: one set of rules that applies if the deceased owner was your spouse, and another set for any other designated beneficiary. We’ll cover spouse beneficiaries first, then non-spouse beneficiaries, then situations in which there are multiple beneficiaries.

Inherited IRA: Spouse Beneficiary

As a spouse beneficiary, you have two primary options:

  1. Do a spousal rollover — rolling the account into your own IRA, or
  2. Continue to own the account as a beneficiary.

Note: there’s no deadline on a spousal rollover. Should you want to, you can own the account as a spousal beneficiary for several years, then elect to do a spousal rollover.

If you do a spousal rollover, from that point forward it’s just a normal IRA (i.e., it’s just like any other IRA that was yours to begin with), so all the normal IRA rules apply, whether Roth or traditional.

If you continue to own the account as a spousal beneficiary, the rules will be similar to normal IRA rules, but with a few important exceptions.

No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59.5, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)

Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax (though not the 10% penalty).

Spouse Beneficiary RMDs
Third, you’ll have to start taking required minimum distributions (RMDs) in the year in which the deceased account owner would have been required to take them. (If the original owner — your spouse — was required to take an RMD in the year in which he/she died, but he/she had not yet taken it, you’re required to take it for him/her, calculated in the same way it would be if he/she were still alive.)

Your RMD from the account will be calculated each year based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590-B.**

Inherited IRA: Non-Spouse Beneficiary

When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.

No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)

Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)

Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a required minimum distribution from the account. (If the account owner was required to take an RMD in the year of his death but he had not yet taken one, you’ll be required to take his RMD for him, calculated in the same way it would be if he were still alive.)

The rules for calculating your RMD are similar (but not quite identical) to the rules for a spousal beneficiary. Again, your first RMD from the account will be calculated based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590-B. However, in following years, instead of looking up your remaining life expectancy again (as a spousal beneficiary would), you simply subtract 1 year from whatever your life expectancy was last year.**

For example, imagine that your father passed away in 2018 at age 65, leaving you his entire IRA. For 2018 (the year of death), you have no RMD. On your birthday in 2019, you turn 30 years old. According to the Single Life table, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2019 would have been equal to the account balance as of 12/31/2018, divided by 53.3.

For 2020, if it weren’t for the CARES Act eliminating RMDs for 2020, your RMD would have been equal to the account balance at the end of 2019, divided by 52.3. (But because of the CARES Act, the RMD for 2020 would be zero.) In 2021, the RMD will be the 12/31/2020 balance, divided by 51.3.

Important exception: if you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.

Successor Beneficiary RMDs
If the original non-spouse beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.

If the original account owner died in 2020 or later, the new rule is that the successor beneficiary (regardless of who it is) will have to distribute the remainder of the account within 10 years of the death of the original beneficiary. (Note: within 10 years of the death of the original beneficiary, not 10 years of the death of the original owner.)

If the original account owner died in 2019 or prior, successor beneficiaries are subject to the same “old rules” as described above for the original beneficiary, with one exception: the successor beneficiary must continue to take distributions each year as if they were the original beneficiary.

By way of illustration, in the example above (with your father, the original owner, dying in 2018) if you were to then die in 2021, leaving the entire IRA to your sister, she would be required to continue taking RMDs from the account according to the exact same schedule you had been taking them, regardless of her own age. So if you hadn’t yet taken your 2021 distribution, she’d have to take it. Her 2022 distribution would be exactly what yours would have been if you were still alive: the 12/31/2021 balance, divided by 50.3.

Tips for Non-Spouse Beneficiaries

  1. When you retitle the account, be sure to include both your name and the name of the original owner.
  2. Name new beneficiaries for the account ASAP.
  3. If you decide to move the account to another custodian (to Vanguard from Edward Jones, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you’d distributed the entire account.

Inherited IRA: Multiple Beneficiaries

If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.

However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size. This is a good thing, because it means that:

  • A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
  • Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.

Note: if the original owner dies in 2020 or later and at least one beneficiary is a “non-eligible beneficiary” (per the definition from the beginning in this article), then the whole account will have to be distributed within 10 years, unless the IRA agreement has a provision that immediately divides the IRA into separate IRAs for each beneficiary.

To split an inherited IRA into separate inherited IRAs:

  1. Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
  2. Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
  3. Change the SSN on each account to be that of the applicable beneficiary.

A Few Last Words

When you inherit an IRA, you absolutely must take the time to learn the applicable rules before you do anything. Don’t move the money at all until you understand what’s going on, because simple administrative mistakes can be very costly.

Also, should you elect to get help with the decision — a good idea, in my opinion — don’t assume that somebody knows the specifics of inherited IRA rules just because he or she is a financial advisor. In these circumstances, I’d suggest looking for someone with CPA or CFP certification.

**If a) the inherited IRA is a traditional IRA, b) you are older than the deceased IRA owner, and c) the deceased IRA owner had reached his “required beginning date” by the time he died, your RMD could actually be smaller than the amount calculated above, as you can calculate it based on what would be the deceased owner’s remaining life expectancy (from the “Single Life” table) using the owner’s age as of his birthday in the year of death (and reducing by one for each following year).

Roth IRA Withdrawal Rules

The whole point of an IRA (Roth or otherwise) is to save for retirement. Unfortunately, things don’t always go as planned, and you may find yourself needing to withdraw money from your Roth IRA before age 59½.

The most important thing to know is this: Contributions (that is, the money that you put into your Roth) can come out at any time, free of taxes and penalties.

Distributions of Earnings

When it comes to distributions of earnings, however, things get a bit more complicated. That’s why I prepared this handy flowchart (and the following explanations) to help you determine whether or not distributions of earnings will be subject to income taxes and/or penalties. 🙂

Please note, this flowchart only applies to earnings when your Roth does not include any amounts converted from a traditional IRA or other retirement plan. If your Roth does include such amounts, please see “Distributions After a Roth Conversion” below.

RothIRADistributions

Qualifying Reasons for Distributions

The following are the “qualifying reasons for distributions” referenced in the first step of the flowchart:

  • You have reached age 59½.
  • The distribution was made to your beneficiary after your death.
  • You are disabled.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.

5-Year Rule

Any earnings distribution prior to the first day of the fifth year after your first Roth was established will be taxed as ordinary income, at whatever your tax rate is at the time.

Example: You open a Roth IRA on May 18, 2016. The 5-Year Rule is satisfied as of January 1, 2021.

Other Exceptions to 10% Penalty

Even if your distribution is not for a “qualifying reason,” you may be able to escape the 10% penalty (but not ordinary income taxes) if any of the following situations apply:

  • You have unreimbursed medical expenses that exceed 10% of your adjusted gross income.
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.
  • The distribution is a qualified birth or adoption distribution (up to $5,000 per birth/adoption).

All Roth IRAs Are Viewed as One

When applying each of the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, once you’ve met the 5-Year Rule for one of your Roth IRAs, you’ve met it for all of them. Also, distributions from a Roth will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2015, you contribute $2,000 to a Roth. In 2016, you open a Roth with a different brokerage firm, and contribute $3,000 to it. By 2017, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA.

Distributions After a Roth Conversion

If, you’ve converted money from a traditional IRA to a Roth IRA, things get slightly trickier.

Distributions of converted amounts will not be taxable as ordinary income (because they’ve already been taxed). The question is whether or not they’ll be subject to the 10% penalty.

Any distributions of converted amounts (assuming they were taxable at the date of the conversion) will be subject to the 10% penalty (though, again, free from ordinary income taxes) if the distribution occurs less than 5 years after the first day of the year in which the conversion occurred. If, however, the distribution was for a “qualifying reason” or you meet one of the “other exceptions” above, the distribution will be free from penalty.

If the conversion included amounts that were not taxable (because they came from a nondeductible IRA), those amounts will not be subject to the 10% penalty even if they are withdrawn from the Roth prior to the first day of the fifth year after the date of the conversion.

Order of Distributions

According to IRS Publication 590B, distributions are assumed to occur in the following order:

  1. Regular contributions.
  2. Conversion and rollover contributions, on a first-in-first-out basis (generally, total conversions and rollovers from the earliest year first). Take these conversion and rollover contributions into account as follows:
    • Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the
    • Nontaxable portion.
  3. Earnings on contributions.

Example: During 2017, you contribute $5,000 to a Roth IRA. You also convert $20,000 from a traditional IRA into your Roth IRA. Of that $20,000, $13,000 was taxable upon the conversion, and $7,000 was not because it came from nondeductible IRA contributions.

In 2018, you withdraw $8,000 from your Roth. The first $5,000 is free from tax and penalty because it’s a return of your contributions. The next $3,000 is assumed to come from the taxable portion of your converted amount. As a result, it will be free from income tax, but it will be subject to the 10% penalty because the distribution occurred prior to the first day of the fifth year after the date of the conversion (unless there is a “qualifying reason” or you meet one of the “other exceptions” above, in which case there would be no 10% penalty).

In 2019, you withdraw another $15,000 from your Roth. The first $10,000 will be the remainder of the taxable portion of the conversion (and will again be free from income tax but subject to the 10% penalty — unless a qualifying reason or other exception to the penalty applies). The remaining $5,000 will be considered to have come from the nontaxable portion of the conversion, and it will be free from both tax and penalty.

Phew!

Admittedly, things can get a bit tricky. Hopefully this helped to clear things up. 🙂

What Counts as Compensation (Earnings) for IRA Contributions?

I’ve received a few questions recently about what types of income count as “compensation” for IRA contribution purposes.

The definition of compensation is important because your IRA contributions for a given tax year are limited to the amount of your “compensation that is includible in your gross income” for the year. (If you are married, you and your spouse’s combined IRA contributions are limited to your combined such compensation.)

There are two key points here:

  1. The income in question must be something that is included in your gross income (e.g., foreign earned income that is excluded would not count), and
  2. It has to be income that counts as compensation.

So what counts as compensation?

Treasury Regulation 1.219-1(c) provides the following definition:

For purposes of this section, the term compensation means wages, salaries, professional fees, or other amounts derived from or received for personal service actually rendered (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses) and includes earned income, as defined in section 401 (c) (2), but does not include amounts derived from or received as earnings or profits from property (including, but not limited to, interest and dividends) or amounts not includible in gross income.

In plain language, that means that the following count as compensation:

  • Wages/salary,
  • Commissions,
  • Net earnings from self-employment,
  • Scholarship or fellowship income if the income is reported in Box 1 of Form W-2 (i.e., reported as wages),
  • Taxable alimony and separate maintenance (i.e., for divorces that became finalized prior to 2019), and
  • Nontaxable combat pay.

And compensation does not include:

  • Interest or dividend income,
  • Other earnings or profits derived from property (e.g., rental income),
  • Social Security benefits,
  • Pension or annuity income,
  • Deferred compensation,
  • Income from a partnership for which you don’t provide services that are a material income-producing factor, and
  • Any income (other than combat pay) that isn’t included in your gross income.

For tax years 2020 and beyond, the SECURE Act made an additional change relating to fellowship/stipend income. Specifically, compensation will also include “any amount which is included in the individual’s gross income and paid to the individual to aid the individual in the pursuit of graduate or postdoctoral study.”

Compensation Reduced by Pre-Tax 401(k) Contributions

One noteworthy point here is that, when it comes to wages, it’s the amount that shows up in Box 1 of your Form W-2 that matters. And this amount in question is reduced by any pre-tax (“traditional”) 401(k) contributions that you make at work. Point being, if your earnings are low enough, pre-tax 401(k) contributions at work could reduce the amount you’re allowed to contribute to an IRA for the year. Roth 401(k) contributions do not, however, reduce the amount in Box 1. So Roth 401(k) contributions would not reduce the amount you can contribute to an IRA.

Should I Roll My 401k into My New 401k or into an IRA?

A reader writes in, asking

“If I’m leaving my employer to take a new position, how should I determine whether to roll my current 401K into the new 401K or into an IRA?”

If you have already decided that you do want to roll your 401(k) somewhere else (e.g., because the old 401(k) has very expensive investment options), there are a handful of factors to consider. Not coincidentally, those factors are very similar to the factors considered when determining whether to roll a 401(k) over to an IRA in the first place.

Where Do You Have Better Investment Options?

If your new employer-sponsored plan has investment options that are better than what you’d have access to in a regular IRA, rolling your money into the new employer plan can be advantageous. Common examples would be people starting a job with the federal government (and who would therefore have access to the super-low-cost Thrift Savings Plan) or people whose new employer plan includes something like Vanguard Institutional share classes (i.e., Vanguard funds with lower costs than Admiral shares).

When Do You Plan to Retire?

If you separate from service with a given employer in or after the year in which you reach age 55, you can take penalty-free distributions from that employer’s 401(k) plan, whereas normally you have to wait until age 59.5 (unless you meet one of a few other exceptions).

As such, if you plan to retire in or after the year you turn 55 but before you turn 59.5, having more money in your final employer’s 401(k) may make it easier to meet your living expenses without having to find another exception to the 10% penalty. If you expect to be in such a scenario (e.g., because you’re age 50 right now when you’re switching jobs and you expect to retire 5-6 years from now), rolling your current 401(k) into your new 401(k) could be advantageous.

Are You Planning Roth Conversions?

If you are planning Roth conversions in your traditional IRA (or you have already done one this year) and your traditional IRA includes amounts from nondeductible contributions (e.g., because you’re executing a “backdoor Roth” strategy), then it can be wise to avoid rolling 401(k) money into a traditional IRA, because doing so would increase the amount of tax you’d have to pay on your conversions.

This wouldn’t necessarily mean, however, that you should roll your old 401(k) into the new 401(k). It might just mean that you should temporarily leave your old 401(k) where it is, with the plan to roll it into an IRA in some future year (e.g., the year after the year in which you do your last Roth conversion).

Expecting a Lawsuit?

I don’t write about this often, as it’s distinctly outside my area of expertise, but in some cases money in a 401(k) may have better protection from creditors than money in an IRA. So if you are expecting to be sued — or you work in a field where lawsuits are common — you should speak with a local attorney to discuss whether your money would be safer in a 401(k) than in an IRA.

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