There is a lot of fuss going on in the retirement planning profession regarding the Department of Labor’s (DOL) new rule holding investment professionals to what is called a “fiduciary standard.” A fiduciary standard requires financial advisers to put their clients’ best interests ahead of their own self-interest. This rule applies to anyone providing advice on retirement accounts – IRAs, Roth IRAs, 401(k)s, etc.
It sounds like a good rule. Many Americans probably thought all advisers were already held to a fiduciary standard. Registered Investment Advisers have always been held to the fiduciary standard but Registered Representatives were not. Now more financial professionals will be considered fiduciaries with respect to advice on retirement accounts.
The tricky part of the new rule is defining when an adviser is acting in the best interest of their client. The rule was particularly targeted to advice concerning rolling over an employer plan to an IRA. A client could have six potential options:
- Leave their money in the employer plan
- Move the money to their new employer’s plan
- Rollover to an IRA
- Convert the funds to a Roth IRA
- Complete an in-plan Roth conversion
- Take the money as a lump-sum distribution
Which option is in the client’s best interest cannot be determined by broad generalizations. Age, health, tax situation, family circumstances, etc. could all be factors. There could be plan specific factors such as after-tax money in the plan, appreciated company stock that may be eligible for an NUA transaction, unique investment options, outstanding 401(k) loan balances, etc.
Rolling funds from a company plan to an IRA is a powerful option, but is not always the best one. The new DOL rule requires advisers to help their clients choose the option that is best for them.
Here are some factors to consider:
IRAs are more flexible than company plans. Most company plans offer a limited number of investment choices; Usually a combination of mutual funds, company stock and a guaranteed option. Even plans that offer a self-directed brokerage option usually limit what type of investments can be held in the brokerage account.
Most company plans have restrictions on withdrawals before age 59 ½. Withdrawals that go directly to the account owner are subject to 20% tax withholding. IRA accounts are easy to access and have no tax withholding requirements, although IRA withdrawals may be taxable and subject to penalty if taken before age 59 ½.
The 2012 Bureau of Labor Statistics reported that the average U.S. worker changed jobs every 4.6 years. The average worker could end up with a lot of employer plans laying around if they didn’t take their retirement plan with them each time. Some employer plans allow new employees to rollover an old company plan to the new one. An IRA rollover is another option for those who don’t have an employer plan at their new job or have one that doesn’t permit rollovers.
Still working exception
Workers who are older than age 70 ½ can delay taking required minimum distributions from their employer plan while they are still working. This rule is not available for funds rolled over to an IRA.
A worker who was at least age 55 when they left their job can take withdrawals from the employer plan before age 59 ½ without tax penalty. Funds rolled over to an IRA would have to wait until age 59 ½ to be penalty free. The withdrawals could still be subject to regular income tax.
Employer retirement plans have federal creditor protection. Although state laws can vary quite a bit, some states offer protection from creditors for IRAs while some states offer no protection at all. IRAs have federal protection in bankruptcy but only to the original owner. Beneficiary IRAs are not protected from bankruptcy.
It is possible to separate after-tax money in an employer plan from pre-tax money at the time of a rollover. The after-tax money can go directly into a Roth IRA permitting tax-free growth going forward. The fact that this can now be deposited directly to a Roth was finally made clear in the latest ruling.
Highly appreciated company stock
Employees who own their company’s stock in their employer retirement plan have the potential for huge tax savings using an often-overlooked tax strategy known as net unrealized appreciation (NUA). An employee who elects to use the NUA strategy, receives the stock in a taxable account, and pays ordinary income tax on their cost of the shares. The appreciation is deferred until the stock is sold and will be taxed at the lower capital gains tax rate.
Many of the details are still being worked out for the new DOL rule. The rule will apply on April 10, 2017 but a transition period for some of the requirements will extend out to January 1, 2018. Advisers should always act in their client’s best interest whether advising on a retirement account or not.
- Registered Investment Advisers have always been held to a fiduciary standard but Registered Representatives are not.
- The tricky part of the new DOL rule is defining when an adviser is acting in the best interest of their client.
- Rolling funds from a company plan to an IRA is a powerful option but is not always the best one.