These accounts include 401(k)s, profit-sharing plans and stock bonus plans. The standard advice is to roll everything over into an IRA. That advice generally makes sense, because you can take over management of your retirement funds while continuing to defer taxes on the income generated.
Arrange for a "Direct" Rollover
If you decide to go the rollover route, arrange for a "direct" or "trustee-to-trustee" rollover from the qualified retirement plan into your rollover IRA. In other words, the check from the company plan should be made out to the trustee or custodian of your new rollover IRA. In some cases, you may be able to arrange for a wire transfer directly into the rollover IRA.
Key Point: While the IRA must be set up in advance to receive the upcoming rollover contribution, the account can be empty prior to the transaction.
Why is a direct rollover important? If you receive a retirement plan distribution check payable to you personally, 20% of the taxable amount of the distribution must be withheld for federal income taxes. You are left with a check for only 80% of the total to deposit into the new account, although you are still responsible for depositing the full 100%.
Now what? You have 60 days to come up with the other 20% and deposit it into the rollover IRA. Otherwise, you will owe income tax on that 20%, plus a 10% premature withdrawal penalty tax will generally apply on that amount if you are under age 55 when leaving your job.
Of course, if you fail to deposit the 20%, you will still be entitled to a federal income tax refund, because the withholding will exceed the actual tax (and 10% penalty if applicable) that you owe. However, you won't get that refund until after filing a tax return for the year the withholding occurs. That could be many months later. Even worse, your rollover IRA balance will be 20% smaller, which means lost tax deferral benefits.
Example: Let's say that after retiring from a job at age 52, you are due $100,000 from the company 401(k) plan. You want to roll over the entire $100,000 into an IRA, but you fail to arrange for a direct rollover. So you receive a distribution check made out directly to you. The amount of your check is only $80,000. The other $20,000 went straight to the IRS for federal income tax withholding. Now you will have to somehow scrape up another $20,000 and get it into your rollover IRA within 60 days to pull off a totally tax-free rollover.
What if you don't complete the transaction in time? You will owe federal income tax on the $20,000, plus you will owe the 10% premature withdrawal penalty tax on the $20,000. In addition, there may be state income tax. Let's assume your marginal federal income tax rate is 25%. The unexpected federal tax bill on the $20,000 would be $7,000 (25% plus 10% times $20,000). You will eventually collect a $13,000 federal refund (the difference between the $20,000 withheld and the $7,000 actually owed). But the whole mess could have been avoided by arranging a direct rollover in the first place.
Key Point: The mandatory 20% federal income tax withholding rule doesn't apply when you are simply rolling over money over from one IRA to another. It only applies to distributions from a qualified retirement plan, such as a 401(k) plan. Keep in mind that you must always meet the 60-day rule, even for an IRA-to-IRA rollover.
Obey the 60-Day Rule
The other big pitfall to avoid with rollovers is failing to meet the 60-day rule. Specifically, you must deposit the retirement account distribution into a rollover IRA within 60 days in order to achieve a tax-free rollover. The 60-day period starts on the day after the funds are received from the company retirement plan and ends on the day you deposit them into your rollover IRA.
Note: Unlike many IRS deadlines, you don't get any extra slack if the end of the 60-day period occurs on a weekend or holiday.
In fact, the only instance when failing to meet the 60-day rule isn't disastrous to your tax planning objectives is if the failure is due to circumstances beyond your control — for example a mistake on the part of the financial institution or brokerage firm. Even in those cases, you have to convince the IRS that you are blameless.
Small Account Balances
Under current law, when a departing employee leaves a 401(k) account with a balance of between $1,000 and $5,000 and does not provide instructions to do so otherwise, the employer is required to open an IRA in the employee's name, and roll the funds into the account. Before the law changed in 2005, the employer could send a check for the balance, minus the 20% federal tax withheld, if the employee didn't arrange for a direct rollover to an IRA. Under these rules, accounts with balances less than $1,000 are still automatically cashed out and subject to taxes and penalties if not properly rolled over. Employees with accounts of more than $5,000 also have the option of leaving the money in the former employer's plan.
Conclusion: Arranging for a tax-free rollover of retirement account money into an IRA seems simple. Nevertheless, failed rollovers occur all the time. Contact your tax adviser if you have questions or want assistance to ensure a smooth, tax-free transaction.
Another point: Until early in 2005, it was a valid concern that money rolled over from a qualified retirement plan into an IRA could potentially become exposed to bankruptcy creditors under applicable state law. Thankfully, that concern has been removed. Federal law now protects from bankruptcy creditors unlimited amounts rolled into an IRA from qualified retirement plans.