How to Handle Retirement Rollovers Correctly
Avoid paying steep taxes and penalties when moving your retirement money.
The topic for this episode is about doing retirement plan rollovers. In last week’s show I mentioned that a rollover is one of the best options for your workplace retirement plan when you leave a job.
What’s a Retirement Rollover?
Even though “doing a rollover” sounds like a cute dog trick, don’t underestimate its ability to save you some serious money on taxes. A tax-deferred rollover occurs when you withdraw cash or assets from one eligible retirement plan and contribute it to another eligible retirement plan within 60 days. When handled correctly, doing a rollover is the best way to move money between retirement accounts. But when not handled correctly, taking money out of a retirement plan can be expensive. I’ll tell you how to avoid paying tax penalties when moving your retirement funds.
Avoid Early Withdrawal Penalties
Just so you know, in this show I’m only going to discuss traditional retirement accounts. There are different rules for Roth accounts, so I’ll save that topic for a future podcast. If you’re a regular show listener, you already know that withdrawing money from a traditional retirement account before you reach the official retirement age of 59½ is a bad idea. That’s because non-qualified withdrawals are usually subject to income tax as well as a 10% early withdrawal penalty (see this episode for a possible way to avoid those early withdrawal fees). But doing a rollover is great because it allows you to take money out of a retirement plan such as a 401(k), 403(b), 457, or an IRA and maintain the tax-deferred status of the funds. Even though a rollover isn’t a taxable event, you still have to report it on your federal income tax return.
How to Rollover Your Workplace Retirement Plan
As soon as you leave a job or prepare to leave, the first step to rolling over eligible retirement funds is to request a distribution form from your employer. Next, you’ll need to make a plan for where you want the money to go. Here’s my quick and dirty tip: open up a new IRA for your rollover funds. You can leave the money in the IRA for the long-term or you can roll it over again into most workplace plans once you’re eligible to participate. You can leave all the rollover money in an IRA and still contribute to a new employer plan—you can have multiple retirement accounts as long as you don’t exceed the allowable contribution limits each year.
The Best Place for your Rollover Money
Consider whether the IRA or a new employer plan is the best place to keep your rollover money. An IRA always gives you more control over your money and usually has many more investment options and flexibility when compared to that of a typical workplace plan. So you’ll probably benefit more from keeping your retirement savings in an IRA, instead of rolling it over into a new workplace plan.
For new retirement contributions—if you have a workplace plan that offers matching funds from your employer—always contribute to it first, before sending money to an IRA. It’s important to take advantage of employer matching because those funds are an instant return on your investment.
Ways to Complete Retirement Rollovers
There are two ways to do a retirement rollover:
- The funds are made payable to you. You deposit the money in a personal account, and then pay it to the custodian of your rollover account within 60 days.
- The funds are immediately made payable to the custodian of your retirement account.
The second way is what I recommend—it’s called a direct rollover. I prefer direct rollovers for two reasons.
Rollovers Subject to Mandatory Withholding
Here’s the first: when you take a retirement distribution in your name it’s always subject to mandatory withholding of 20%, even if you intend to roll it over in time. With direct rollovers there’s never any withholding taken out.
Consider this example: Let’s say you leave your job and have $10,000 in your 401(k). Maybe you’re not sure where you want to move those funds (last week's episode could help with that), but you know you want to do a rollover. So you elect to have the $10,000 distribution made payable to you. When you get the check from the retirement account, it’s only $8,000. That could be a big shocker if you’re not familiar with how a rollover works! The trustee of your employer’s plan is required to withhold 20% of all taxable distributions made to plan participants. So 20%, or $2,000, of your $10,000 account balance automatically got shipped off to the government to pay your federal income taxes, even if you plan to complete a rollover within the allowable 60 day period.
If you don’t have $2,000 of your own money to replace the withheld amount, you’ll only be able to rollover the $8,000 you received. If you complete the rollover in time, the withheld amount will come back to you as a tax refund when you file your income taxes the following year. But during that entire time your $2,000 is being held by the government—instead of working for you in your retirement account!
Don’t Miss the Rollover Deadline!
The second reason I prefer a direct rollover to taking a retirement distribution in your own name is that if you happen to miss the 60 day deadline for completing the transaction, the money gets included as income to you. As I mentioned, that means not only having to pay income tax, but also having to pay an early withdrawal penalty. So a direct rollover works to your advantage because it leaves less room for a potential tax error to occur and doesn’t require mandatory tax withholding.
If you ever have questions about doing a rollover, it’s important to get advice from your retirement plan custodian. They can walk you through the process to make sure you don’t break the rules and end up with a rollover that you wish you could do-over.
For more about retirement, be sure to get my audiobook Money Girl’s Guide to Retirement Planning. It’s full of advice, resources, and quick tips to help you take control of your financial destiny. It’s on sale at Audible.com and in the iTunes store.
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