Investor Education | IRA rollovers: a tax‐smart maneuver

When you take a distribution from an employer's retirement plan, you generally owe tax on the payout. However, with a timely move, you can continue to postpone paying the tax until you are ready to make withdrawals.

Basic premise: There is no current income tax liability on a distribution from a qualified retirement plan if you "roll over" the funds within 60 days. For example, if you have a 401(k) account at your job and you are retiring, you can transfer all the funds to an IRA without paying any tax.

Frequently, you were required to roll over the entire amount in your account balance with a lump-sum distribution. Now you might decide to take advantage of a partial rollover. Any portion of a distribution not rolled over is taxed as ordinary income.

In addition, rollovers could be used only upon separation from serving or upon reaching age 59½. Depending on your employer's plan, in-service distributions are permitted.

Nevertheless, 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 10 years or more).
  • Required minimum distributions (RMDs) required to be made upon reaching the age of 70½.
  • Payments to someone other than the employee or his or her spouse.
  • Payments of nondeductible contributions made to the plan.
  • Payments to correct excess contributions or excess deferrals.
  • Loan amounts treated as distributions by the IRS.
  • Hardship distributions.

Furthermore, if you receive a qualified retirement plan payout, income tax is automatically withheld at a 20% rate, even if you intend to roll over the funds to an IRA within 60 days.

You cannot recoup this amount until you file your income tax return for the year of the distribution. To make matters worse, you may also be assessed a 10% penalty tax for withdrawals prior to age 59½. The penalty is equal to 10% of the taxable portion of the withdrawal.

Key exception: There is no withholding requirement for a trustee-to-trustee transfer. This is the preferred approach for the majority of plan participants.

Say you're age 55 and you are expecting to receive a $100,000 distribution from your qualified retirement plan. If you arrange to directly transfer the $100,000 to the trustee of the IRA, you avoid both the 20% withholding requirement and the 10% penalty tax.

Of course, there are other factors to consider when you receive retirement plan distributions. For example, you may want to time receipt of a distribution for a year when you expect to be in a lower tax bracket. Note that different tax rules apply to transfers to a Roth IRA.

Is the rollover move right for you? It depends on your situation.

Key Tax Reforms on the Table

During his successful candidacy, President Trump pledged to usher in sweeping tax reforms. Some of the key items on his agenda are as follows:

  • Reductions in both individual and corporate tax rates.
  • A cap on itemized deductions.
  • Repeal of the federal estate tax modification of the step-up in basis rules.
  • Elimination of the 3.8% surtax on net investment income (NII). The NII tax was included in the Affordable Care Act (ACA).
  • Repeal of the alternative minimum tax.

Will any of these changes occur? We will update you on any significant developments.

This newsletter/advertisement is produced for our clients, friends and associates through an arrangement with WPI Communications, Inc. for the representatives’ use. Although the editorial content is professionally researched, written and edited, neither our firm nor any of its agents, representatives or associates make any representations regarding the accuracy of the content or its applicability to your situation. The information in this communication is not intended as tax or legal advice. In accordance with IRS Circular 230, the information provided herein may not be relied on for purposes of avoiding any federal tax penalties. Any tax advice contained in the body of this material was not intended or written to be used, and cannot be used, by the recipient for the purpose of 1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or 2) promoting, marketing or recommending to another party any transaction or matter addressed herein. You are encouraged to seek tax or legal advice from an independent advisor.

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