The Internal Revenue Service allows you to create special individual retirement accounts, called conduit IRAs, to received rolled over funds from your employer's retirement plan, such as a 401(k). Keeping the money in a conduit IRA allows you to roll it over to another employer's retirement plan later. IRS rules require that conduit IRAs not be commingled with any other money. If, for example, you roll over funds from your 401(k) into your existing traditional IRA, this would be a "non-conduit" IRA -- meaning that you wouldn't be allowed to move the money to another qualified retirement plan later.
When you are eligible to remove money from a qualified retirement plan --for example, if you leave your job -- you may want somewhere to park it until you can participate in another employer's plan. You can roll over all or part of it to a conduit IRA, set up specifically for this purpose. You may leave the money in the conduit IRA indefinitely, or you can choose to roll it over to another qualified plan, without tax consequences. If on the other hand, the 401(k) funds were paid directly to you, without a rollover to an IRA, you'd pay taxes and possibly penalties on the withdrawal.
Any IRA that's not specially set up as a conduit IRA might be termed a "non-conduit" IRA, because it cannot serve the functions of a conduit IRA. It cannot serve as a pipeline from one qualified retirement plan to another. Once you mix the money from your employer's plan with an existing IRA -- that is, any IRA that already has other funds in it -- or once you add additional money to the IRA, you've "commingled" it. This means you lose the ability to move the money that came from your former employer's plan to another employer's retirement plan in the future. This is not necessarily the end of the world -- you can keep the money in your IRA and still enjoy tax-deferred growth of your retirement money -- but it does take away some flexibility.
Why Choose Conduit IRAs?
Generally, the IRS allows a 60-day period to roll over funds taken from a qualified retirement plan to another qualified plan. In most cases if you wait longer than 60 days, the money counts as a permanent withdrawal. In other words, it's treated as income, so you must pay income taxes on it, as well as any tax penalties that apply for taking money from a retirement account early. The beauty of the conduit IRA is that it allows you to continue to defer taxes and penalties beyond the 60 days -- you can begin participation in a new employer’s plan whenever you're eligible.
Other Disadvantages to Non-conduit IRAs
There are certain tax advantages associated with an employer's retirement plan that are not available to owners of IRAs. For example, if you had a long-term 401(k) you might qualify for a tax benefit known as "10 year forward tax averaging" if you were to take out a large sum later in retirement. This benefit would allow you to spread out your tax bill over 10 years instead of paying it all in one year -- which IRAs require you to do. If you move money from your employer's retirement plan into a non-conduit IRA, you lose any of these associated tax benefits as well. You must follow the IRA rules instead.