Tax-favored retirement accounts are a great way to save for your golden years, but some of the rules that govern them can be obscure. For instance, the tax laws provide for the use of what's known as a conduit IRA, which is an IRA into which you can roll over money from one employer retirement plan and then later move that money back into another employer retirement plan. Some brokers refer to conduit IRAs as rollover IRAs, but regardless of what they're called, these accounts can give you maximum flexibility in handling your retirement savings if you're careful in managing them correctly. Below, we'll look more closely at conduit IRAs and whether you need one.
The key to understanding conduit IRAs
IRS Publication 590 specifically discusses conduit IRAs and how they can be helpful for retirement savers. As the publication notes, those who take an eligible rollover distribution from an employer plan account can roll over part or all of the money into one or more conduit IRAs. You can then manage and invest the conduit IRA like any other retirement account, choosing investments and getting the benefit of tax deferral as long as the money remains inside the IRA.
What a conduit IRA allows that other IRAs don't is the ability to move that money back into another qualified employer plan at a later date without any adverse consequences. Specifically, the publication notes that as long as you don't make any regular contributions to the conduit IRA or add funds from other sources, you will remain eligible for any beneficial tax treatment under which the contributions would have qualified.
Some simple examples
The situation in which this most often comes up is when someone changes jobs. If you quit your job and immediately start working at another job, then it's easy to do a direct rollover of your old job's 401(k) or other retirement plan directly to the new job's 401(k) plan. That solves the need for any additional moves of your retirement money.
However, if you quit without having another job lined up, you can use a conduit IRA to handle the intermediate period. Roll your old 401(k) money into a conduit IRA, and then you can later arrange to move it into the new 401(k) once you get a new job. Moreover, if your new job doesn't offer a 401(k) or other retirement plan, you can keep the conduit IRA, and then roll it into a subsequent 401(k) if you change jobs again.
When conduit IRAs are most helpful
Conduit IRAs have become much less important for most taxpayers because some of the tax benefits that are available for using them have largely gone away. For example, those who were born before 1936 can treat lump sum distributions from pension plans differently than other taxpayers. The portion of plan profits that was derived from participation before 1974 can qualify for preferential tax treatment as capital gains rather than ordinary income. In addition, a special tax formula using forward-average treatment can result in your paying less tax than you otherwise would.
Since most of those who are 80 or older have already taken any lump sums to which they're entitled, the benefits of a conduit IRA have for the most part disappeared. As a result, most retirement savers feel comfortable commingling rolled-over IRA money with any contributions that they've made. Note, however, that some financial institutions are still very careful about keeping funds from various sources separate, so you might still end up using a conduit IRA -- even if you don't specifically direct your financial provider to do so.
Nevertheless, using conduit IRAs can be a good way for you to track how much you've saved for retirement through employer retirement plans, compared to your own contributions to a separate IRA. By making sure you can move money from one retirement plan to another without having to pay any taxes or penalties, a conduit IRA can be an invaluable tool in your retirement saving arsenal.