Thanks to tax reform, defined benefit plans are becoming increasingly popular. But numerous questions persist over the distribution rules. The most important of which is – can a defined benefit plan be rolled over into an IRA? Let’s take a close look at the defined benefit plan rollover.
A defined benefit plan is very different from a 401k. The sponsoring company will contribute a percentage of an employee’s salary into an investment account. The company will invest this money and then provide a retirement distribution to the employee’s upon retirement.
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The defined benefit plan rollover
But circumstances often change. People get concerned that when they set up a defined benefit plan are not allowed to change the plan or even terminate it. As the IRS sees it, the plan is permanent in nature and cannot be randomly terminated for an invalid reason.
The IRS simply assumes the plan will last indefinitely. But it is typically acceptable to the IRS to terminate the plan as long as it is in existence for at least a “few years.”
However, the tax code is somewhat vague. It doesn’t specifically define what a “few years” means. The IRS states that the plan can only be terminated if and when there is a business necessity to do so.
A business necessity most likely exists when the company has lower cash flows or profits, there is a significant change in ownership, or there is a material event that prevents or inhibits its ability to fund the plan on an ongoing basis. The IRS will normally allow the company to adopt a substitute or alternate plan as a reasonable cause for plan termination. This is also the case for a solo plan.
From a mere practical standpoint, the IRS will generally not question a plan termination when a plan has been in place for at least 10 years. However, a company that terminates a plan that was started at least 5 years prior to termination will not typically receive any inquiry from the IRS.
Can a defined benefit plan be rolled over into an IRA?
So let’s assume that you can terminate your plan. Can the defined benefit plan be rolled over into an IRA? The law is relatively straightforward regarding this issue. You can take money out of the defined benefit plan as a complete lump sum distribution.
Alternatively, you are allowed to take the lump sum balance and roll it over into an IRA. Please note that partial distributions or partial rollovers are not allowed.
Because any funds in a defined benefit plan are pre-tax, you can elect to deposit or transfer the funds to a traditional IRA. If you then choose, you can convert the funds to a Roth IRA and pay the taxes immediately.
A traditional IRA functions like the defined benefit plan in that all taxes are deferred until money is disbursed in retirement. A Roth IRA represents after-tax money. Once tax is paid on conversion, the funds are deposited in the Roth IRA account and is subject to the holding period rule.
Before you decide to terminate your plan and roll it over into an IRA, make sure you discuss the issue with your third party administrator.
So can a defined benefit plan be rolled over into an IRA? The answer is an absolute yes. But before any termination, make sure that you thoroughly discuss the process with your accountant and administrator. Only then can you ensure that you can keep your distance from the IRS.