There's a lot written all over the web and elsewhere about what to do with retirement plan rollovers, like 401(k) plans, 403(b) plans and even IRAs.
But rarely discussed is what to do with a 457 rollover. As luck would have it, we received just such a question on Ask GFC:
Can a distribution ($50,000) from a 457 plan be “rolled over” into an existing Roth IRA that is over 5 years old? Is there any time limit before that money could be withdrawn? I realize taxes will need to be paid, but are there any other restrictions?
The reader asks about what to do with a 457 rollover, and mainly as it might relate to a rollover/conversion into a Roth IRA. I'm going to get into the Roth IRA conversion aspect, but I'm thinking to go a bit broader, and also cover a 457 rollover into a traditional IRA.
For those who aren't familiar with a 457 plan, it's identical to both 401(k) and 403(b) plans in most respects.
The main difference is that it's a retirement plan offered by state and local governments, and some tax-exempt organizations. But the rollover considerations are also very similar to what they are for 401(k) and 403(b).
Can a 457 Rollover Be Made Into a an Existing Roth IRA?
In a word, absolutely! The options for a 457 rollover are the same as they are for other types of retirement plans. You can do a 457 rollover into a Roth IRA, which of course means that you are doing a Roth conversion.
Just as you would with any type of Roth conversion, any portion of the 457 rollover balance that is comprised of either tax-deferred contributions or investment income earned in the plan, will be subject to ordinary income tax upon conversion.
However, there is no 10% early withdrawal penalty on the rollover amount, even if you are under age 59 1/2 at the time of the conversion.
Once you reach age 59 1/2, and as long as the Roth IRA has been established for at least five years, any distributions taken are completely tax free.
There's one other important benefit to the Roth IRA. They do not require that you begin taking Required Minimum Distributions (RMDs) from the plan at age 70 1/2. Virtually every other tax sheltered retirement plan does require RMDs. But if you have a Roth IRA, you can literally keep the money in the plan for the rest of your life.
That reduces the possibility you might outlive your money, but also means you'll have more money to leave to your heirs at the time of your death.
It's an excellent plan, so it's easy to understand why the Ask GFC reader is asking about it as a potential destination for his 457 rollover.
Limits on Withdrawals of Roth Conversion Funds
The Ask GFC reader asks if there is any time limit before the conversion balance can be withdrawn. Since he references that the 457 rollover balance will be rolled over – actually converted – into an existing Roth IRA that is over five years old, he's really asking if he will have access to the funds immediately, based on the fact his Roth account has met the the five year rule.
But the answer is no.
The five year old account will benefit him for ongoing direct Roth IRA contributions. He can withdraw the amount of those direct contributions since the account itself has met the five year limit. But that doesn't apply on Roth IRA conversions.
According to IRS regulations, each Roth conversion resets the clock for another five year limit. That is, if he converts the funds from the 457 rollover to a Roth IRA now, he will have to pay the 10% early withdrawal penalty on the amount withdrawn until at least five tax years have passed since the conversion (the exception is if he is already over age 59 1/2).
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Further, he will have to pay both the penalty and ordinary income tax on any amount of the withdrawals from the Roth IRA that represent investment income.
But just remember, we're talking strictly about the 457 rollover/Roth conversion balance here, not his existing Roth IRA account, or any subsequent direct Roth IRA contributions.
Plan B: 457 Rollover into a Traditional IRA
The reader didn't ask this question, but it's a consideration that needs to be discussed in regard to a 457 rollover. The reader doesn't give us any background information, such as his age, whether or not he is working, or what tax bracket he's in. Those are all relevant considerations for any type of rollover, but especially if the rollover might involve a Roth IRA conversion.
The funds can remain in the IRA, building more investment income on a tax-deferred basis, and growing until age 59 1/2, when you can begin taking distributions, free from the early withdrawal penalty.
The disadvantage of doing the 457 rollover into a traditional IRA is when the distributions are taken, they will be subject to ordinary income tax.
Unlike the Roth IRA conversion, which forces you to pay the tax on the distribution now in exchange for tax-free withdrawals later, the rollover into the traditional IRA avoids taxes now, but requires them upon withdrawal. (A traditional IRA, unlike a Roth IRA, is also subject to RMDs beginning at age 70 1/2.)
But even without the tax-free distributions in retirement, doing the 457 rollover into a traditional IRA might still make more sense than doing a Roth conversion.
Traditional or Roth IRA – Which is the Better Route for a 457 Rollover?
The answer to this question really depends on the information the Ask GFC reader didn't provide – his age, employment status and income tax bracket. For that reason, I'm going to keep this part of the discussion very general. Even though we don't have the reader's background circumstances, there are still important factors to consider anytime you do a rollover of any sort.
A Roth conversion generally makes more sense if you are in a lower income tax bracket. For example, if your combined federal and state marginal tax rate is 20%, the tax bite on the reader's $50,000 457 rollover would be $10,000 ($50,000 X 20%). A Roth conversion will make a lot of sense if the reader expects to be in a similar or higher tax bracket during retirement.
However, if the reader has a combined federal and state marginal tax rate of 40%, the 457 rollover will result in a $20,000 tax ($50,000 X 20%). It also has to be considered that adding $50,000 to the reader's income could easily push him into a higher tax bracket. That's because the amount of the 457 rollover will be added to his other taxable income in the event he does a Roth conversion.
Now if the reader expects to be in a lower tax bracket during retirement, say 20%, the Roth conversion may not make as much sense. That's because he will be incurring a 40% tax liability now, in exchange for a 20% tax break later.
If the reader is say, 35 years old, it might still be worth doing a Roth conversion. Even with the 40% tax, the account will have 25 to 30 years to grow through investment earnings. But if on the other hand, he is say, 55, doing the conversion now won't leave much time to grow the account before retirement.
Strategy to Consider: Delayed Roth Conversion
We still don't know the specifics of the reader's background situation, but here is a suggestion that might incorporate both a traditional IRA and the Roth conversion.
If the reader is primarily interested in moving his money from an employer directed 457 plan into a self-directed IRA, he can do that by moving the money into a traditional IRA, if his marginal income tax rate would make a Roth conversion particularly costly.
By doing the 457 rollover into a traditional IRA, the reader avoids creating a tax liability related to the rollover. But that doesn't completely remove the Roth conversion from consideration.
He can do the 457 rollover into a traditional IRA now, and then do a Roth conversion – from the traditional IRA to a Roth IRA – when he reaches retirement. If his income will drop in retirement, resulting in a lower marginal tax bracket, it may make more sense to do a Roth IRA conversion at that time.
He will still have to pay ordinary income tax on the amount of the conversion. But as long as he is at least 59 1/2 years old, he can withdraw the amount of the conversion free from tax and the early withdrawal penalty. He'll then have to wait a minimum of five years to begin withdrawing the portion of the Roth IRA that represents investment income.
But that would give him access to the Roth IRA funds in retirement, with the ability to withdraw tax-free income.