If you’ve left your job, doing an IRA rollover of the balance in your company retirement plan is usually a tax-smart move. A rollover allows you to continue to defer taxes on the amount you roll over. But our beloved Congress laid some federal income tax traps for the unwary. Don’t be among the unwary. Here’s how to avoid the pitfalls.
1. Arrange direct transfer from company plan into your IRA
After exiting your old job, you’ll probably want to roll over money from your former employer’s qualified retirement plan (or plans) into an IRA. That way, you gain full control over the funds while continuing to defer taxes. But there’s a tax trap to avoid. Dodge it by arranging for a direct trustee-to-trustee transfer from the plan into your IRA. In other words, the check or EFT from the plan should go directly to the trustee or custodian of your IRA. While you must have an IRA set up and waiting to receive the transfer, the account can be empty before that.
Here’s why doing a direct transfer is key: if you receive a retirement plan check that is payable to you personally or a distribution that is dumped into a personal account via an EFT, 20% of the taxable amount of the payout must be withheld for federal income tax. Then you’ll have 60 days to come up with the “missing” 20% and get it into your IRA. Otherwise, you can’t accomplish a totally tax-free rollover. You’ll owe income tax on the 20% and maybe the dreaded 10% early withdrawal penalty tax too if you’re under age 55. Here’s an example.
Example: After leaving your job at age 50, you’re due $300,000 from the company 401(k) plan. You want to roll over the entire amount, but you fail to arrange for a direct transfer. So, you receive an EFT to your personal account in 2022. Surprise. The EFT is only for $240,000. The “missing” $60,000 went to the U.S. Treasury for mandatory 20% federal income tax withholding. Oops.
Now you have to somehow scrape up $60,000 and get it into your IRA within 60 days to pull off a totally tax-free rollover. Say you manage to do that. Great. But you can only recover the $60,000 that went to the Feds by making reduced federal income tax payments over the remainder of 2022 or by claiming a refund when you file your 2022 return sometime next year. Either way, it will take a while to get your $60,000 back.
If you fail to scrape up the “missing” $60,000 and roll it into your IRA within 60 days, you’ll owe federal income tax on the $60,000 (because it wasn’t rolled over) plus you’ll probably owe another $6,000 for the 10% early withdrawal penalty tax (because you’re under age 55). Not good.
What to do: Avoid the whole mess by arranging for a direct transfer of the $300,000 into your IRA.
2. Avoid rollover in this situation
If you’re 55 or older when you receive a payout from your former employer’s qualified retirement plan, you won’t owe the 10% early withdrawal penalty tax on money you choose to keep in your own hands by not rolling or transferring the amount over into an IRA. You’ll owe federal income tax and maybe state income tax on the amount you keep outside of your IRA. But at least you dodge the 10% penalty tax.
In contrast, if you roll or transfer the money into your IRA and then need to withdraw some or all of that amount before age 59½, you’ll generally owe the 10% early withdrawal penalty tax on top of the income tax hit. Ouch.
What to do: Plan ahead to avoid getting unnecessarily slammed with the 10% penalty. If you’re going to need some of the money that you’re thinking about rolling over, don’t roll it over.
3. You might not want to roll over company stock held in your retirement plan account
In an earlier column, I explained special federal income tax rules that may dictate against rolling over appreciated employer stock that’s held in your company retirement plan and distributed to you after you quit. You may be better off putting those company shares into a taxable brokerage firm account. For the details, see this previous Tax Guy column.
The bottom line
You would think that arranging for tax-free rollovers of employer retirement plan balances into IRAs would be a relatively foolproof task. But our beloved Congress has dictated otherwise — for inexplicable reasons that illustrate why you don’t want the government controlling your life. That’s why I hear about failed rollover attempts — and unnecessary tax hits — year after year with no end in sight. Please carefully read the wisdom revealed here, and seek advice from a tax pro if you have rollover questions involving any sizable amount.
Sidebar: Beware of weird one-IRA-rollover-per-year rule
After you’ve rolled over company retirement plan balances into your IRA, you may want to arrange one or more IRA-to-IRA rollovers for whatever reason. For instance, maybe you want to set up separate IRAs for each of your beneficiaries, and then transfer an existing IRA balance to fund the new accounts.
The general rule says that you can withdraw all or part of an IRA balance and then roll it back into the same IRA or another IRA with no taxes owed, as long as you put the money back within 60 days. Great, but there’s a tax trap.
You can only do one of these IRA-to-IRA rollovers within any 12-month period. If you take two or more withdrawals within that period, the extra withdrawal(s) will count as taxable distributions that can trigger an income tax hit and the 10% early withdrawal penalty tax if you’re under age 59½. Why this weird limitation? Who knows, because it serves no logical tax-policy purpose that I can detect.
Thankfully, you can dodge the one-IRA-rollover-per-year trap by moving money from one IRA into another via direct trustee-to-trustee transfers that don’t ever pass through your hands. Strangely enough, these transfers don’t count as rollovers for purposes of the one-IRA-rollover-per-year limitation. Why not? Once again, who knows? (Source: IRS Revenue Ruling 78-406.)
Another helpful loophole says that rolling over a distribution from a qualified retirement plan, such as a 401(k) plan, into your IRA doesn’t count as a rollover for purposes of the one—IRA-rollover-per-year limitation. Go figure. (Source: IRS Regulation 1.402(c)-2, Q&A-16.)
What to do: Take advantage of these loopholes for any IRA-to-IRA transfer. That way, you’ll never have to worry about the goofy one-IRA-rollover-per-year trap.