Reg. BI’s 401(k) Rollover Obligations

The SEC’s new Regulation Best Interest (“Reg. BI”) imposes a set of obligations on broker-dealers when giving advice to retail customers.  Reg. BI in part targets transactions involving 401(k) rollovers into an IRA.   

These tend to be one-shot transactions where the interests of the broker-dealer do not necessarily coincide with the long-term interests of their customers. What exactly does Reg. BI require of broker-dealers in the rollover context?  And aside from Reg. BI, when does it make sense to roll over retirement plan account assets into an IRA?  

Reg. BI’s General Obligation

The SEC’s Reg. BI applies to brokers, dealers, and natural persons associated with them (“broker-dealers”) in their dealings with retail customers and their legal representatives.  Broker-dealers must comply as of June 30, 2020.   

Retail customers include natural persons who receive advice for personal, family or household purposes. Legal representatives can include trustees, executors, and persons holding power of attorney.   

The general obligation of a broker-dealer is to act in a retail customer’s best interest without placing the financial or other interest of the broker-dealer “ahead” of the interest of the customer.  

Comment: This formulation does not say that a broker-dealer must place the interests of the customer first.  Some critics have described this formulation as a “tied is good enough” standard.  Perhaps the SEC thought it unrealistic to expect more or to enforce a stricter standard.   

Breaking Down Reg. BI’s Obligations

To satisfy the general obligation, the broker-dealer has particular obligations to: 

  1. disclose in writing potential conflicts of interest;  
  2. exercise care in making a recommendation;  
  3. establish, maintain, and enforce policies and procedures that address conflicts of interest; and 
  4. establish, maintain, and enforce policies and procedures to ensure compliance with Reg. BI.  

Under the care obligation, the broker-dealer should use reasonable efforts to understand the risks, rewards, and costs associated with the recommendation. Any recommendation must be based on the customer’s investment profile. That would include (but not be limited to) the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, and risk tolerance. 

Comment: Starting May 1, 2020, both SEC-regulated broker-dealers and financial advisors must file and provide Form CRS Relationship Summary to any potential retail customer.    

Reg. BI and Plan Rollovers

Reg. BI applies to recommendations to open an IRA or to roll over assets into an IRA.  Under Reg. BI’s care obligation, a broker-dealer must:  

  1. have a reasonable basis to believe that the IRA or IRA rollover is in the best interest of the retail customer at the time of the recommendation, and 
  2. not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer.  

In making a recommendation, a broker-dealer must take into consideration a retail customer’s investment profile plus advantages and disadvantages of rolling over from an employer retirement plan to a personal IRA.  

Reg. BI Rollover Factors

According to the SEC, factors to consider under the Reg. BI care obligation include:  

  • fees and expenses;  
  • level of service available; 
  • available investment options;  
  • ability to take penalty-free withdrawals;  
  • application of required minimum distributions;  
  • protection from creditors and legal judgments;  
  • holdings of employer stock; and  
  • any special features of the existing account.   

Caution: The SEC has said that the available-investment-options factor does not simply mean “more investment options.”  Broker-dealers should consider available investment options in an IRA, among other relevant factors, in light of the customer’s current situation and needs in order to develop a reasonable basis to believe that the rollover is in the retail customer’s best interest. 

Financial Advisors Distinguished

Financial advisors also routinely give rollover advice.  Financial advisors, however, are subject to a more flexible standard of care and loyalty rather than the due diligence list under which broker-dealers must operate.   

The SEC distinguishes between broker-dealers who earn a commission on a transaction, and investment advisors who earn a fee based on the value of the assets in the customer’s portfolio.  The SEC’s view is that a financial advisor’s interests line up pretty well with the client’s long-term interests. They both do better financially with a portfolio that grows over time.  That is not true with a broker-dealer who earns a commission on each transaction.   

Financial Advisors and the Fiduciary Interpretation

In addition to Reg. BI, the SEC has recently issued a “Fiduciary Interpretation” which applies to financial advisors and their clients.  Unlike Reg. BI, the Interpretation applies for all customers not just retail customers.   

The Interpretation it does not include the explicitly spelled out obligations that Reg. BI imposes.  It is a more flexible standard, application of which in enforcement actions depends in large part on the situation.   

The Interpretation states that financial advisors are obligated to act in the best interests of their clients.  As with Reg. BI, the SEC fleshes this out by saying that this duty requires that an advisor not place its interests ahead of the customer’s. The SEC claims that this is the same standard that the SEC has been applying in practice.  

Comment: The SEC is obligated to enforce a fiduciary standard for financial advisors under the Investment Advisors Act of 1949, and has some experience in this matter.  

Things to Consider When Deciding Whether to Roll Over 401(k) Assets into an IRA

The Reg. BI list of rollover factors mirrors concerns retirement plan experts have identified over the years when deciding whether to roll 401(k) assets over to an IRA.  Here are some of the considerations.   

Reasons to leave assets in a 401(k) include: 

  • 401(k) participants may take distributions without owing additional tax starting at age 55 instead of 59 ½ if they separate from service; 
  • 401(k) participants generally have stronger protections against creditor liability, which might be especially important for professionals or small business owners; 
  • 401(k) participants who would otherwise not have to start taking required minimum distributions (RMDs) at age 72 because they are still working would have to start making RMDs if they have rolled over into an IRA; 
  • 401(k) participants who would otherwise be allowed to borrow against their accounts would lose that right if they roll over into an IRA; 
  • 401(k) participants who would otherwise qualify for capital gains treatment of net unrealized appreciation on lump sum distributions of employer stock would lose this benefit if they roll over to an IRA; and 
  • 401(k) participants born before 1936 who would otherwise qualify for special tax treatment available for lump-sum distributions would lose this benefit if they roll over into an IRA. 

Advantages for rolling assets over into an IRA include: 

  • IRA owners can take early distributions without incurring the 10 percent additional tax if they take a series of equal payments, or use the proceeds for qualified education expenses, qualified first-time home purchases, health insurance premiums if unemployed, or roll the distribution over into a Health Savings Account; 
  • IRA owners can choose a brokerage IRA for maximum investment flexibility, or a mutual fund IRA for low fees; 
  • IRA owners have wealth transfer planning advantages: any number of separate IRAs can be created to facilitate estate planning and provide maximum flexibility for post-death elections, IRA owners can make qualified charitable distributions effectively allowing tax free rollovers of RMDs to a charity; 
  • IRA owners have more flexibility regarding the Roth feature since they are not dependent on plan terms to provide for designated Roth accounts and in-plan rollovers; recharacterization of rolled over amounts is allowed for Roth IRAs, and Roth IRAs are free from minimum distribution requirements while the owner is living; for nonqualified distributions from Roth IRAs, nontaxable contributions are deemed to be distributed first and then taxable earnings, whereas for designated Roth accounts, nonqualified distributions are pro-rated between nontaxable Roth contributions and taxable earnings; and 
  • IRA owners may take distributions at any time as long as they are willing to pay income tax on the withdrawn amount and (if applicable) the 10 percent additional tax for early withdrawal, but 401(k) assets are locked up by law until the participant reaches age 59 ½, severed employment, becomes disabled or dies.  

Conclusion

Deciding whether to roll over plan assets to or from an IRA can be a complex choice as there are many factors to weigh.  REG BI essentially imposes due diligence rules on broker-dealers to at least raise and consider the common factors as they apply to a particular customer.  These rules give broker-dealers considerable leeway, however, to build a case for what they would like the customer to do.   

The best approach for most retail customers is to think this through independently.  Reg. BI’s list of factors is to a certain extent reinventing the wheel on this topic. Accordingly, there is a lot of advice and experience out there that can be tapped.   

By James Solheim, J.D.

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CCHTaxGroup

All stories by: CCHTaxGroup