Benefit from a rollover to an IRA

If you receive a distribution from an employer’s retirement plan, such as a 401(k), you are generally required to pay ordinary income tax on the payout. However, with a timely maneuver, you can continue to postpone paying the tax until you are ready to make withdrawals.

Basic rules: There is no current income tax liability on a distribution from a qualified retirement plan if you “roll over” the funds within 60 days. For example, if you have a 401(k) account at your job and you are retiring, you may transfer all the funds to an IRA without paying any tax.

In the not-so-distant past, the rollover rules were much more restrictive than they are now. For example, you were required to roll over the entire amount of your account balance with a lump-sum distribution. Now, you might decide to take advantage of a partial rollover. Any portion of a distribution that is not rolled over is taxed as ordinary income.

In addition, rollovers could be used only upon separation from service or upon reaching age 59½. Now, depending on your employer’s plan, in-service distributions are permitted.

Additional reading: How to Bridge the Retirement Shortfall

Nevertheless, certain qualified plan distributions are not eligible for tax-free rollover treatment. The list includes these items:

  • Annuity payouts (e.g., regular pension payouts geared to your life expectancy or a period of 10 years or more)
  • Required minimum distributions (RMDs) required to be made upon reaching the age of 70½
  • Payments to someone other than the employee or his or her spouse (e.g., payments to your child as beneficiary)
  • Payments of nondeductible contributions you have  made to the plan
  • Payments to correct excess contributions or excess deferrals
  • Loan amounts treated as distributions by the IRS
  • Hardship distributions

Furthermore, if you receive a qualified retirement plan payout, income tax is automatically withheld at a 20% rate, even if you intend to roll over the funds to an IRA within 60 days.

You cannot recoup this amount until you file your income tax return for the year of the distribution. To make matters worse, you may also be assessed a 10% penalty tax for withdrawals prior to age 59½. The penalty is equal to 10% of the taxable portion of the withdrawal.

Key exception: There is no withholding requirement for a trustee-to-trustee transfer. Say that you’re age 55 and you are receiving a $100,000 distribution from your retirement plan. If you have your plan administrator directly transfer the $100,000 to the trustee of the IRA, you then avoid both the 20% withholding requirement and the 10% penalty tax.

Of course, there are other factors to consider when you receive retirement plan distributions. For example, you may want to time receipt of a distribution to a year when you expect to be in a low tax bracket. Note that different tax rules apply to transfers made to a Roth IRA.

Ultimate question: Should you roll over to an IRA or not? It all depends on your personal situation. Discuss the options with your professional advisers.  Check out the JMF Company Directory.