3 major IRA rollover tax pitfalls to watch out for
3 major IRA rollover tax pitfalls to watch out for, When you roll over an IRA, it’s far too simple to break harsh tax laws. You can keep deferring taxes on the money you roll over thanks to an IRA rollover. However, there are some federal income tax pitfalls to avoid. Don’t be one of the foolish.
If you’ve quit your work, rolling over your remaining corporate retirement plan balance into an IRA is typically a tax-efficient choice. Taxes on the money you roll over can still be put off thanks to a rollover. However, the unwary were caught in some federal income tax traps set by our loving Congress. Don’t be one of the foolish. Here’s how to stay clear of them.
Plan a direct transfer of funds from your company plan to your IRA.
You should probably transfer funds from your prior employer’s qualifying retirement plan (or plans) into an IRA after leaving your current position. In this manner, you continue to put off paying taxes while gaining complete control over the funds. There is a tax trap to avoid, though. By setting up a direct trustee-to-trustee transfer from the plan into your IRA, you can avoid it. In other words, the trustee or custodian of your IRA should receive the check or EFT from the plan directly. The account might be empty prior to receiving the transfer, but you must have an IRA set up and ready to receive it.
Doing a direct transfer is important because, if you get a retirement plan check payable to you directly or a distribution that is deposited into a personal account via an EFT, federal income tax withholding of 20% of the payout’s taxable amount is required. After that, you’ll have 60 days to find the “missing” 20% and deposit funds into your IRA. You cannot complete a rollover that is completely tax-free if you do not. If you’re under 55, you may also be subject to the dreaded 10% early withdrawal penalty tax in addition to the 20 percent income tax. Here is one instance.
Example: You are entitled to $300,000 from the corporate 401(k) plan after quitting your work at age 50. Even if you wish to roll over the entire sum, you forget to set up a direct transfer. So, in 2022, you get an EFT into your personal account. Surprise. There is just a $240,000 EFT. The allegedly “lost” $60,000 was used to pay the statutory withholding of 20% of federal income taxes to the US Treasury. Oops.
Now, to pull off a completely tax-free rollover, you must somehow scrape together $60,000 and deposit it into your IRA within 60 days. Say you succeed in doing that. Great. However, you can only recoup the $60,000 that was paid to the government by claiming a refund when you submit your 2022 return later next year or by paying smaller federal income tax payments during the rest of 2022. It will take some time to receive your $60,000 back, any way.
You’ll owe federal income tax on the $60,000 (since it wasn’t moved over) as well as extra $6,000 for the 10% early withdrawal penalty tax (because you’re under age 55) if you don’t find the “lost” $60,000 and roll it into your IRA within 60 days. Very bad.
What to do: Arrange for a straight deposit of the $300,000 into your IRA to avoid the entire situation.
When rolling over, avoid doing so.
If you’re 55 or older when you receive a distribution from a qualified retirement plan of your former employer, you won’t be subject to the 10% early withdrawal penalty tax on funds you decide to hold on to by not rolling or transferring the money into an IRA. The amount you retain outside of your IRA will be subject to federal income tax as well as any state income tax. But at least you avoid paying the 10% penalty tax.
On the other hand, if you roll over or transfer the funds into your IRA and later need to withdraw any or all of that sum before the age of 5912, you will typically owe the 10% early withdrawal penalty tax on top of the income tax hit. Ouch.
What to do: Make a plan in advance to prevent being unnecessarily hit with the 10% penalty. Don’t roll over the money if you may require some of the funds that you are considering doing so.
If you have corporate stock in your retirement plan account, you might not want to roll it over.
I previously discussed the unique federal income tax regulations that may forbid rolling over valuable employer stock that is kept in your employer retirement plan and distributed to you after you leave the company. Putting your stock shares in a taxable brokerage account can be a better option for you. For information,
You might assume that setting up tax-free rollovers of company retirement plan balances into IRAs would be a very simple process. But for mysterious reasons that highlight why you don’t want the government to have control over your life, our beloved Congress has mandated something different. That’s why I keep hearing year after year, with no end in sight, about failed rollover attempts and needless tax hits. If you have any issues about rollovers involving a large amount, please take the time to carefully read the advice provided here and consult a tax expert.
Warning: Strange one-IRA-rollover-per-year regulation
After you’ve transferred assets from your employer’s retirement plan into your IRA, you might decide to arrange one or more IRA-to-IRA rollovers for any number of reasons. For instance, you might decide to create individual IRAs for each of your beneficiaries, then move funds from an existing IRA to the new accounts.
As long as you roll the money back into the same IRA or another IRA within 60 days, you can generally remove all or part of an IRA amount without having to pay taxes on it. Good, but beware of the tax trap.