When done right, rollovers can be a great tool

When rollovers are done right, no taxes are due.

Dear Dan,

I understand why someone might roll funds out of a 401(k) plan, but why would anyone under 591/2 ever roll money into a 401(k) and lock it up?

-Wondering About Withdrawals

Dear Wondering,

Normally, withdrawals from a retirement plan trigger taxes and a penalty if taken prior to age 591/2. Rollovers are transactions that allow the movement of funds from one retirement plan to another. When done right, no taxes are due.

There are many reasons to roll money out of a 401(k), with the most common being the employee leaves a job and prefers those funds be in an IRA. You typically have a much wider selection of investment options and are not required to meet any qualifications to get funds out of an IRA. If you need cash, you need only make the distribution request and be prepared to pay the taxes and any applicable penalty.

But 401(k)s and other retirement plans operate differently. Unauthorized distributions can disqualify a plan, causing severe financial consequences, including immediate income taxes and any applicable penalties for employees on their vested balances.

Despite the more complex rules, we regularly see funds rolled from IRAs into qualified retirement plans such as 401(k)s and 403(b)s. People do this because rolling funds into a plan often facilitates another maneuver and the funds are often still accessible.

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Generally, 401(k) balances are considered "locked up" because participants need a qualifying event to take a distribution. These "distributable events" include severance from employment (e.g., resignation, termination or retirement), the disability or death of the participant, required minimum distributions (RMDs) starting at a certain age, and plan termination.

However, plans may include language allowing additional access under specific circumstances. They may allow in-service withdrawals of elective deferrals, including Roth and safe-harbor contributions, after a participant reaches age 591/2; hardship withdrawals, subject to a slew of special rules; or withdrawals of non-Roth after-tax contributions and - notably, to your question - rollover contributions.

When such provisions are included, participants may generally access non-Roth after-tax contributions and rollover contributions at any age without satisfying a qualifying event. So, funds rolled into a plan with such a provision are not as locked up as one might think.

As for maneuvers that make rollovers into a plan useful, three are common.

First is avoiding the pro rata rule for Roth conversions. If you have a $100,000 IRA with $10,000 of after-tax contributions in it, 90% of any amount you convert to a Roth IRA will be taxable. If, instead, you roll the $90,000 of the IRA that has never been taxed into a 401(k) that accepts IRA rollovers, you could then convert the remaining $10,000 to a Roth IRA and pay no tax because that money has already been taxed. Keeping pretax money out of IRAs can also enable so-called backdoor Roth IRA contributions in future years.

Second, when someone separates from service in or after the year they turn 55 (or 50 for some public-service workers), they may access funds in the plan from that now-former employer without paying the 10% penalty that usually applies to pre-591/2 distributions. This age-55 exception does not apply to IRAs; distributions will still be taxable, but by rolling pretax IRA money into the plan prior to separation from service, pre-591/2 penalty-free access becomes available from that specific former employer's plan. If you want to access an IRA early without penalty, you must be eligible for one of the penalty exceptions applicable to IRAs.

Lastly, the law allows plans to include language permitting workers old enough to be subject to RMDs to skip them while working for the company sponsoring the plan. Other plans from former employers and IRAs do not have such an exemption. By rolling funds from those other plans or IRAs into the current employer's plan, workers do not have to contend with RMDs until they stop working.

If you have a question for Dan, please email dan@moisandfitzgerald.com with "MarketWatch Q&A" in the subject line.

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-Dan Moisand