When Is a Rollover IRA NOT a Rollover IRA?

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When you see or hear the term rollover IRA, you probably think it has a simple definition and that the rules are easy to follow. But that isn’t the case: It’s just as easy to make mistakes with rollover IRAs as it is to use them properly.

What exactly is a Rollover IRA, how does it differ from other types of IRAs and what are the benefits? Here's what you need to know.

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Today, we’ll help you figure out exactly what a rollover IRA is, and show you how to use it.

Let’s start with a definition: A rollover IRA is a type of traditional IRA that is used to receive assets from an employer-sponsored retirement plan, such as a 401k. Since these retirement assets were contributed to the employer-sponsored plan on a pre-tax basis, the account holder will want to use a rollover IRA to keep the status of those assets strictly tax-deferred.

So if you are a participant in a 401k plan, and it’s time to terminate employment, you’ll need to establish a rollover IRA at a brokerage firm or mutual fund company to receive your rollover.

As a note, the custodian of your IRA likely will offer a Roth IRA. However, Roth IRAs can only use funds that have already been taxed, making them a less-than-ideal place for your pre-tax 401k funds. Instead, you’ll want to receive your pre-tax 401k contributions in a traditional IRA, which uses pre-tax money.

So the very first thing to remember when you’re completing forms to open a new IRA to receive your 401k rollover: If you don’t see a checkbox on the form that is labeled “rollover IRA,” don’t panic. Just check the box that says “traditional IRA.”

Further Defining Rollover IRA

Once you’ve successfully rolled over your retirement assets into the new rollover IRA, it’s wise to do more than just invest the assets — you’ll want to keep those assets tax-deferred.

Prior to 1993, a rollover IRA was referred to as a “conduit IRA.” This term comes from the Internal Revenue Code, which required that these IRAs only hold rollovers from qualified plans, such as 401k plans. No other money — not even new pre-tax contributions made subsequent to the rollover — could be held. Therefore, the old-school, conduit IRA was a rollover IRA in the “purest” sense.

But things have changed.

The reason for this distinction in the code was that only a pure rollover IRA could qualify for a rollover back into a 401k plan. If the account holder added new money to the rollover money, the code considered it a commingling of funds, and the account was then considered a contributory IRA, not a rollover IRA.

Fortunately, the code no longer requires rollover IRAs — or what they called conduit IRAs — to remain pure in this sense. Today, if the account holder of a rollover IRA commingles new money with the rollover assets, the rollover IRA can still be rolled back into a 401k, as long as the new money purely consists of tax-deductible contributions. (Let the IRS be your guide as far as tax-deductible contribution limits go.)

Why It’s Smart to Keep Your Rollover IRA Pure

Although the code no longer makes a real distinction between a rollover IRA and a contributory IRA, it can still be smart to keep rollover assets separate from contributory assets.

In other words, consider keeping your rollover assets in one traditional IRA, and your new and ongoing pre-tax contributions in a second, separate traditional IRA.

Why?

Let’s say you have the fortune of making too much money to qualify for pre-tax contributions to a traditional IRA or after-tax contributions to a Roth IRA. Sometimes it can make sense to make non-deductible contributions to a traditional IRA. There are no income limits on making these after-tax contributions to a traditional IRA. Just be sure to keep good records.

Also, in the event of bankruptcy, rollover IRAs are pretty heavily shielded.

For example, as a result of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, IRAs have a certain degree of protection from bankruptcy … however, rollover IRAs have the greatest degree of protection.

Bankruptcy protection for contributory and Roth IRAs is limited to $1 million, adjusted for inflation. However, assets in rollover IRAs receive complete protection and are thus not limited to $1 million. Likewise, 401ks have this complete level of bankruptcy protection, which further underscores the wisdom of keeping rollover assets separate from contributory IRA money.

For high-net-worth investors, for individuals who may eventually reach this status or for those who want to protect assets above $1 million from bankruptcy, it is prudent to keep rollover IRAs purely rollover IRAs.

Kent Thune is the owner of a privately held investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent tax advice or a recommendation to buy or sell securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2016/03/rollover-ira-not-one/.

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