Line up an IRA rollover

Suppose you’re getting ready to call it quits or sell your company. The good news is that you’ve accumulated a tidy nest egg in your company retirement plan. The bad news: You will owe a hefty tax bill if you take a lump-sum payout. Strategy: Roll over the plan balance into an IRA. Assuming you meet certain requirements, you won’t owe any tax on the transfer.

What’s more, the assets in your IRA can continue to grow free of tax until you’re ready to start taking withdrawals or you’ve reached a certain age. Here’s the whole story: If you receive a distribution from your company retirement plan, such as a 401(k), you are required to pay income tax on the payout at ordinary income rates reaching as high as 37%. However, by rolling over the funds into an IRA within 60 days, you can continue to postpone tax until you are ready to start taking withdrawals or until you must begin taking annual required minimum distributions (RMDs). You’re required to begin taking RMDs from your IRA(s) after turning age 70 ½.

The 60-day deadline is critical. If you go past it, the payout is treated as a taxable distribution, even if you intended to roll it over into an IRA. Warning: Certain qualified plan distributions are not eligible for tax-free rollover treatment. The list includes these items:
Annuity payouts (e.g., regular type pension payouts geared to your life expectancy or a period of ten years or more)

Annual RMD amounts that must be taken after age 70 ½ if you still have a balance in the plan at that late date.

Payments to correct excess contributions.

Past due plan loan amounts treated as taxable plan distributions.

But that’s not all. For instance, if you receive a qualified retirement plan payout, federal income tax is automatically withheld at a 20% rate, even if you intend to roll over the funds to an IRA within 60 days.

Furthermore, you can’t recoup this amount until you file your income tax return for the year of distribution. To make matters worse, you may also be assessed a 10% early withdrawal penalty tax for withdrawals taken before age 55 if you are leaving the company. The penalty equals 10% of the taxable portion of the early withdrawal.

Key exception: There’s no federal income tax withholding requirement for a trustee-to-trustee transfer from your plan to your IRA. Say that you’re age 55 and you expect to receive a $500,000 distribution from your retirement plan. Instruct your plan administrator to directly transfer the $500,000 to the trustee of your IRA. That way you avoid the 20% federal income tax withholding requirement.

Of course, there may be other factors to consider when you receive retirement plan distributions. For example, you may time receipt of a distribution in a year when you expect to be in a lower tax bracket than you are now.

Finally, you have other options at your disposal, such as leaving the money in the 401(k) or transferring the assets to a Roth IRA that can provide future tax-free distributions.
Three keys for staying put

You don’t necessarily have to leave your company’s 401(k) plan just because you stop working there. Strategy: If it makes sense, keep the assets there if the plan allows that. There are three key factors.

  • Fees: IRAs usually have no annual fees. However, 401(k)s often charge a percentage of the assets, perhaps as high as 2% a year.
  • Investment performance: Although IRAs offer more investment options than 401(k)s, you may prefer the status quo based on past and expected investment performance.
  • 401(k) rules: If the rules for your company’s 401(k) are restrictive, it may be time to get out.

Tip: Consider any extenuating circumstances.

Small Business Tax Strategies
July 2019