Tax Tips
Making Sense of IRA Rollovers - July 2007
Richard Scrivanich - Partner
Many people save for retirement in a tax-deferred, employer-sponsored plan such as a 401(k), Keogh, or profit-sharing plan. As long as you’re a participating employee, you’ll have the benefit of tax-deferred accumulation.
At some point, though, you will decide to work for another company or retire. By then, your retirement account may be among your most valuable assets. Deciding what to do with that account can be a critical part of your financial plan.
A common choice is to roll over the balance to an IRA. This strategy has several advantages. Inside an IRA, tax deferral will continue. You can choose your own investments and coordinate them with your non-IRA holdings. And your nonspousal beneficiaries may have more flexibility in taking distributions from an IRA than from an employer plan, if you leave a balance when you pass away.
Option plays
However, an IRA rollover is not your only choice. Instead, you may be able to decide among the following alternatives:
Take all the money from the tax deferred account. This will put cash in your pocket right away. Any money you get, though, will be taxable income. You also may owe a 10% early withdrawal penalty, depending on your age.
Keep the money in your former employer’s plan. Many plan documents allow departing employees to keep their money in place. Depending on your account balance, the law may require your plan to keep the money.
Roll the balance from your former employer’s plan to your new employer’s plan. If you’re moving to a different company, the plan there likely will accept transfers, permitting continued tax deferral. In some cases, there may be a waiting period before you can contribute to the new plan.
Divide your funds. You can withdraw some of the money in your employer-sponsored plan, pay tax (and perhaps a penalty) on the withdrawal, and roll the remainder into a tax-deferred IRA or your new employer’s plan.
Rewards of not rolling
Why would you choose one of the above options, rather than a full rollover? Obviously, cash needs are critical. You may want to pay down debt or buy a vacation home, for example.
In addition, creditor protection is a key issue for some people. Under the new bankruptcy law, rollover IRAs are subject to the same protection as employer-sponsored retirement plans. ERISA (a federal law) generally keeps creditors from going after money held in employer-sponsored retirement plans. However, this federal creditor protection is limited (generally to $1 million) for regular IRAs, including an existing IRA to which you make a rollover. The creditor protection of regular IRAs is also subject to state law, and not all states extend full protection to IRAs. Therefore, you should check your state’s law before executing an IRA rollover. If creditor protection is important to you, you should roll the money into a brand new IRA.
Another reason for passing up an IRA rollover might be an intention to go into semi-retirement, working part-time. If you roll the money into an IRA, you must start taking distributions (and paying income tax) after you reach 70 ½.
In a company plan, tax deferral can continue as long as you are still working. To qualify for this extended deferral, you can’t own more than 5% of the company. If you’ve already rolled your money into an IRA, you may be able to avoid taking minimum distributions if you roll that money back into your employer’s plan.
Finally, the investment choices in your former employer’s plan may be more attractive than anything you can find on the outside. If that’s the case, leaving your money behind may make sense.
Roll the right way
If such issues don’t concern you, an IRA rollover likely will be the best choice. If so, always specify a “trustee-to-trustee transfer” from your employer-sponsored plan to your IRA custodian. Keep your hands off the money being rolled over. If you handle the funds personally, 20% of the money withdrawn from the account will be withheld for federal income tax.
Suppose you roll over a $500,000 account from your company plan and you take possession of the funds. Of your $500,000, $100,000 (20%) must be withheld. You’ll have to make up the difference with $100,000 from your own pocket to avoid owing income taxes and possibly a $10,000 (10%) penalty. You’ll get credit for the $100,000 of withholding when you file your tax return.
New Tax Act Provision Allows Regular to Roth Conversion Beginning in 2010
Under a provision of the recently enacted Tax Increase Prevention and Reconciliation Act, rollovers from traditional to Roth IRAs will be available to higher income individuals beginning in 2010. Taxpayers who might find such a conversion attractive include those who are relatively young and expect substantial appreciation before retirement and also those who expect that they will not need funds early in retirement (because Roth IRAs do not require distributions to begin no later than 70 ½). Taxpayers who expect to make the conversion should save to pay the taxes that will be due on the conversion, although they may take advantage of the option of paying the taxes due over two years. Assuming that Congress won’t change the provision, taxpayers might consider making non-deductible IRA contributions now and converting traditional 401(k)s into rollover IRAs to increase amounts eligible for conversion.
If you have any questions regarding IRA rollovers or any other tax matter, please feel free to give me a call at (562) 698-9891.
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