This week, Gail explains what you have to do to avoid botching a 401(k) rollover and when it's safe to make withdrawals from a Roth IRA.

 

Gail,

I have a 401 K valued at about 35K. My employer has declared chapter 11 and has now closed the doors. I have a new position with another company that does not offer a 401(k) — yet. I don't want to wait around and get hit with penalties. I am expecting a check in the full amount sometime soon. Should I start my own plan, probably an obvious answer; yes. But what kind of plan, is best for my circumstances? I am 45, married with two children. My current employer is talking about starting a 401(k) but I don't want to go through this again.

Thanks if you can help.

Ed B.

 

Dear Ed —

As an individual, you don't have the legal right to just "set up your own" retirement plan of choice. Retirement plans are always tied to an employer, except in the case of IRAs. Unless there is a retirement plan at your new job that you could roll your old 401(k) into, your only choice is to roll your 401(k) balance into a traditional IRA within 60 days of receiving your distribution.

This is a critical deadline! If you don't roll the proceeds of your 401(k) into an IRA within that time period, you can never re-deposit that money into a tax-sheltered retirement plan of any type. At your age, that means you'll lose at least two decades of tax-deferred growth.

Worse, you'll have to declare the entire distribution as income for 2004 and pay income taxes on it. Topping this off, since you are under age 55, you'll also get hit with a 10% penalty for an early withdrawal.

The bottom line: don't miss the 60-day rollover window.

But even if you meet the deadline, your troubles aren't over.

When you get the check: you will NOT receive "the full amount." By law, when you receive a distribution from a qualified plan such as a 401(k), your employer must withhold 20 percent of the amount. Don't worry: this doesn't mean that your old company is keeping the money. It's got to be sent to the IRS. Think of the 20 percent withheld as a down payment on the income tax you'd owe if you changed your mind and didn't roll over your distribution. It's the IRS's way of persuading you that rolling over is smarter than keeping the cash.

But here's the really big problem:

If you want to avoid income tax on 100 percent of the amount in your 401(k), you have to rollover 100 percent of the value of your 401(k). Except, as I just mentioned, by law your employer is only allowed to give you a check for 80 percent of the amount!

Which means you've got to come up with the "missing" 20 percent, or it will be classified as "distributed" and you'll get hit with ordinary income tax and a 10 percent penalty on this amount.

In your case, your 401(k) is worth $35,000. However, you will receive a check in the amount of $28,000 ($35,000 minus 20 percent). In order to avoid income tax and a 10-percent penalty on the $7,000 that was withheld, you have to make up the shortfall yourself . It gets added to the check you get from your employer so that your rollover amount is $35,000.

Don't worry, you'll get your $7,000 back when you file your income taxes next year. In the meantime, though, you're out the money.

I know, I know. It isn't fair. It's lousy. But that's the way it works.

Sorry for the bad news,

Gail

P.S. There is one way you might be able to avoid all of this hassle, Ed. If you haven't received your distribution yet, contact your former employer and ask whether the plan will allow a direct rollover of your account to an IRA. In a direct rollover, the plan makes your distribution check payable not to you, but directly to the IRA or new employer plan that you are rolling over to.

The great part about this is that, because the check is not being made payable to you, the IRS does not require any amount to be withheld. One hundred percent of your account would be rolled over to your IRA and no amount would be subject to tax or penalty (until you later withdraw it from your IRA). So you would not have to come up with additional funds in order to avoid tax and penalty in connection with your rollover. The plan may not allow a direct rollover — but in that case, you know where you stand now, and it is certainly worth the trouble to inquire!

 

Gail,

I am 60 years old and have been contributing the max to a Roth for the past eight years. The money has been invested in several different mutual funds according to my asset allocation.

1. If I wanted to withdraw ALL the money today, would it ALL be tax free, or only the portion that has been invested over 5 years? Or would all the principal be tax free but not earnings from less than 5 years? Or is there some

other rule I should be aware of?

2. If the money had been invested in one fund would it make any difference?

I foresee a record-keeping nightmare unless the mutual fund has been keeping this sorted out.

I requested a copy of IRS Pub 590 in December but have not received it.

Thanks, Linda

 

Dear Linda —

First of all, the annual contributions you make to a Roth IRA can be withdrawn tax AND penalty-free no matter how old you are and no matter how long they've been in your account.

Let me put this another way: You can contribute to a Roth IRA today and withdraw the money you contributed tomorrow — and there will be neither tax nor a penalty imposed.

Why? Because you already paid income tax on this money! You may hate all of the mind-numbing complexities and seeming unfairness of our federal tax system (see above), but it is consistent in this respect: you are not required to pay tax twice on the same income.

Since, by definition, Roth contributions must come from "after-tax" money, you do not have to pay tax on this again. Think of the "pass" you get on the penalty part as a small "gift" from the IRS.

The "5-year" rule you're thinking of kicks in if you withdraw more than the total amount of your contributions, that is, you start dipping into the earnings those contributions generated.

For this purpose, the 5-year "clock" starts on the date the Roth IRA was opened, regardless which contributions those earnings are tied to.

In your case, you're home free: IF you are at least age 59 1/2 AND the Roth IRA has been open at least 5 years, even the earnings can be withdrawn tax-free and penalty-free.

Since you obviously are comfortable using the internet, Linda, why don't you just download a copy of IRS Publication 590 (which covers IRAs). You can find it at: http://www.irs.gov Just type "Publication 590" into the box.

for finding forms and publications in the upper left-hand corner of the IRS's home page.

Hope this helps!

Gail

 

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