IRA to 403(b) rollover--Penalty Tax

[Guest JROSSITTER]

IRA may be rolled over to a 403(b). As far as I know, no separate accounting is required (unlike 457 plan). A participant who terminates employment after age 55 may take a distribution without penalty tax. If distribution includes IRA funds, the penalty tax that would otherwise apply to an IRA withdrawal is avoided. Am I missing something, or is this a loophole?

[E as in ERISA]

I think that it may be a loophole that the IRS just confirmed in Rev. Rul. 2004-12:

"However, a distribution of amounts attributable to a rollover contribution is subject to ... the additional income tax on premature distributions under § 72(t), as applicable to the receiving plan. Thus, for example, if a distribution from an IRA is rolled over into a plan described in § 401(a), any distribution from the § 401(a) plan of amounts attributable to the rollover would be subject to the exceptions from the § 72(t) tax that apply to § 401(a) plans and not the exceptions that apply to IRAs."

There is a special rule for 457 plans in 72(t)(9), but I see nothing for 403(b)s.

[Guest Yanikoski]

Yes, it's a loophole, if that's all you care about. In the IRA you can withdraw at ANY time if you are willing to either pay the 10% penalty or use the 72(t) rules to take periodic payments. In the 403(b), you CANNOT take money out before age 59-1/2 unless you are severing employment or meet one of the other exeptions -- even if you are willing to pay the penalty!! So your flexibility can be seen as increased or decreased, depending on your circumstances. The IRA also gives you a lot more flexibility in terms of investment options; with a 403(b) it has to be either an annuity or mutual funds.

The IRS was resistant to cross-plan rollovers for a long time just because of this kind of "loophole." But when Congress passed EGTRRA, the IRS clearly realized that it made more sense to get into the spirit of portability than to impose a lot of picayune restrictions. One big exception to that is rollovers into 457 plans, since 457s don't have the 10% penalty at any age, and that was too big of a loophole for the IRS to swallow. But transfers among other kinds of plans are not across-the-board giveaways. They all involve trade-offs, and if in any given case the exchange works well, then by all means go for it, with the IRS's blessing. But look before you leap!!

[mbozek]

Y: the restriction on in service distributions prior to 59 1/2 does not apply to withdrawals of employer contributions from a 403(b) annuity contract. The restrictions on withdrawal apply only to employer contributions to mutual funds (403(b)(7)) and employee salary reduction contributions (403(b)(11).

[Guest JROSSITTER]

Thanks guys! In the absence of a separate accounting rule, the IRS really has no choice. And since the 457 accounting rule is statutory, they would be hard pressed to justify a regulatory separate accounting rule for 403(b)s and 401(a)s.

The real legislative/policy question is why there should be a separate rule for IRAs. An individual who terminates all employment after age 55 is subject to the penalty for IRA distributions, but a 403(b) or 401(a) participant who terminates after 55 and goes to work elsewhere can take penalty free withdrawals.

[mbozek]

Because IRA distributions have always been available at any time subject only to the 10% penalty whereas qualified plan money is usually available only at termination of employment. Prior to 87 distributions from qual plans were not subject to any penalty for distribution prior to 59 1/2. Congress imposed the 10% penalty for distributions from qual plans prior to 59 1/2 to raise revenue but made an exception for payments made after termination after 55.

[Guest JROSSITTER]

The new RR goes beyond our issue. If the receiving plan chooses (or is required) to separately account, it may permit the distribution of the rollovers at any time:

HOLDING

If an eligible retirement plan separately accounts for amounts attributable to rollover contributions to the plan, distributions of those amounts are not subject to the restrictions on permissible timing that apply, under the applicable requirements of the Internal Revenue Code, to distributions of other amounts from the plan. Accordingly, the plan may permit the distribution of amounts attributable to rollover contributions at any time pursuant to an individual’s request.

Thus, for example, if the receiving plan is a money purchase pension plan and the plan separately accounts for amounts attributable to rollover contributions, a plan provision permitting the in-service distribution of those amounts will not cause the plan to fail to satisfy the requirements of § 1.401-1(b)(1)(i). Similarly, if the receiving plan is a § 457 eligible governmental plan or a tax-sheltered annuity described in § 403(b)(7) or (11), amounts attributable to rollovers that are maintained in separate accounts are permitted to be distributed at any time even though distribution of other amounts under the plan or contract is restricted pursuant to § 457(d)(1)(A) and § 403(b)(7) or (11), respectively.

However, a distribution of amounts attributable to a rollover contribution is subject to the survivor annuity requirements of §§ 401(a)(11) and 417, the minimum distribution requirements of § 401(a)(9), and the additional income tax on premature distributions under § 72(t), as applicable to the receiving plan. Thus, for example, if a distribution from an IRA is rolled over into a plan described in § 401(a), any distribution from the § 401(a) plan of amounts attributable to the rollover would be subject to the exceptions from the

§ 72(t) tax that apply to § 401(a) plans and not the exceptions that apply to IRAs.