Chances are you'll have to roll over a retirement account at least once in your lifetime. Most likely, it will be when you leave your current employer and take your 401(k) with you. Or, you may be eligible to roll over your current IRA into a Roth. Here's what you need to know in order to get each rollover right.
Avoiding the 20% Withholding Trap
Leaving your current job? Then you've got a great opportunity to roll over your 401(k) into an IRA. This will give you many more investment options than either leaving the money in your old 401(k) or rolling it over into your new employer's plan. (Each of those options is available at the discretion of the employer.)
If you ask, your company will be only too happy to send you a check for the full vested balance of your account. If the company makes the check out to you, however, it is required to withhold 20% for taxes. That leaves you between a rock and a hard place. You will have to cough up the missing 20%, or pay a 10% penalty on the withdrawal if you are under age 59 1/2. You won't get the withheld money back until you file your taxes the following year (assuming your salary withholding and any other tax payments for the year exactly equal your tax bill).
To avoid the 20% withholding, you must arrange for a "direct" rollover (known as a "trustee to trustee" rollover). Put simply, this means the distribution check from the retirement plan at your old company must be made out in the name of the trustee or custodian of the IRA account that you want to receive the rolled-over funds. Ask the bank or brokerage house that will function as the IRA trustee or custodian for specific written instructions on how the check should be made out. It will be something like: "Huge Securities Corporation, for the benefit of John Q. Public."
The next step is to notify your former employer's retirement plan administrator that you are making a direct rollover. You will probably be told to fill out a form, which will include a place for you to give instructions on how the distribution check should be styled. When you get the check, simply deposit it in the rollover IRA within 60 days.
To meet the 60-day rule, start counting on the day after you receive the check and include the day you deposit the money into your IRA. For example, if you get the check on Sept. 1, you must get the money into your IRA on or before Oct. 31. There's no extension for weekends or holidays.
When an IRA Doesn't Pay
Let's say your company retirement plan account holds some appreciated employer stock, and you leave your job. You may be better off withdrawing the shares and holding them in a taxable account instead of rolling them over into your IRA. (You can still roll over everything else.) Assuming the shares are received as part of a lump-sum distribution (a complete liquidation of all your company retirement accounts in the same calendar year), you'll be taxed only on the amount the plan paid for the stock. But if the stock has been appreciating, this could be a small fraction of current market value (although this could still be a significant number).
The tax is at ordinary income rates, but here's the benefit: The net unrealized appreciation when the shares are distributed to you (the difference between the market value and the plan's cost for the shares) will qualify for the 20% maximum long-term capital gains rate (10% if you're in the 10% or 15% income-tax bracket). Even better, that capital gains tax is deferred until you sell the shares. Any additional appreciation also qualifies for the 20% rate if you hold the shares more than 12 months before selling. (Starting in tax-year 2006, shares held more than five years will be taxed at a maximum rate of 18%.)
Last but not least, if you die while still owning the shares, your heirs will get a basis step-up for all appreciation after the shares come out of your retirement account up to the date of death. This means that appreciation never gets taxed. In contrast, if you roll the shares over into an IRA, you or your heirs will eventually pay tax at ordinary rates -- up to 38.6% in 2003; 37.6% in 2004 -- on all these gains when withdrawals are made from the account. And there's no break for your heirs if the stock is still in your IRA when you pass away.
What Comes Out Must Go Back In
A recent tax court decision answered a long-standing question about IRA rollovers. If you take cash from a qualified retirement plan account, you must roll over cash into your IRA, rather than some other asset of equal value. Ditto if you are simply rolling funds from one IRA to another. You cannot, for example, do what the poor guy in the court case did and use cash withdrawn from a retirement plan or IRA to buy stock and then attempt to roll over the shares. If you try this type of maneuver, the door is shut on any rollover and you'll be taxed on the withdrawal.
If you are not 59 1/2, you will generally owe the 10% "premature withdrawal" penalty tax as well. What should you do? Roll over the cash into your IRA and then buy the stock. (The taxpayer in the court case couldn't wait because he had to meet a stock subscription deadline.)
Now if you withdraw stock from a qualified plan or IRA account, it's OK to roll those shares over into an IRA. In fact, it's mandatory. You can't sell the shares and then roll over an equal amount of cash, nor can you roll over different shares of equal value. So the rule for tax-free rollovers is: cash to cash, stock to stock, and ashes to ashes.
Using an IRA Rollover As a Short-Term Borrowing Source
Every so often you may face a temporary cash crunch when you desperately need some extra dough, but just for a short time. You will have the necessary cash in a month or so, but that doesn't help right now. A potential solution is "borrowing" from your IRA account, which can be done with virtually zero paperwork, no delays from balky loan officers, and no interest charge.
You simply withdraw the needed funds and make sure you then replace the money within 60 days. You are considered to have made a tax-free IRA rollover.
The money can be deposited back into the same IRA account it came from or into a different account, but each account can receive only one of these rollover deposits during any 365-day period. ("Direct" or "trustee-to-trustee" rollovers from another IRA into the account in question don't count for purposes of the one-year waiting period rule, nor do rollovers of distributions from qualified retirement plans.) But remember: If these guidelines are violated, you are considered to have made a taxable IRA withdrawal, and you may owe the 10% premature withdrawal penalty.
Rollovers to Split IRAs in a Divorce
In connection with a divorce, you may transfer some or all of your IRA funds to your ex-spouse. This happens all the time as part of splitting up a divorcing couple's assets, and it's a tax-free deal if and only if you follow these two steps:
First, the split of your IRA assets must be required pursuant to your divorce settlement.
Second, the split must be accomplished by rolling funds over from your IRA into an IRA set up for the other party. The other party then treats the rollover IRA as his or her own. When funds are withdrawn, it will be your ex-mate who owes the resulting taxes. Fair enough because that's what you both expect.
But any other transaction that has the effect of transferring your IRA funds to your spouse or ex-spouse -- before or after a divorce -- will cause you to owe income taxes. This is because you are deemed to have taken a taxable IRA withdrawal and then turned around and handed the money over to the other party of your own free will. If you are under 59 1/2 at the time, you'll get socked with the 10% premature withdrawal penalty as well.
This tax fiasco can happen before your divorce is final if, for example, you voluntarily try to help your soon-to-be-ex with his or her cash flow problems by doling out some of your IRA money with the idea it will be rolled over into the other person's IRA. This seems very reasonable, because you already know he or she is going to wind up with at least that much of your IRA money anyway. And it only makes sense that a tax-free rollover is permitted in this situation. Right?
Unfortunately, being so cooperative will cost you. Your spouse can't roll the money over because the tax laws don't allow this except when an IRA split is required under a divorce agreement. But don't expect to hear any complaints, because you'll get stuck with the tax bill for the IRA withdrawal while the other side winds up with tax-free cash (at your expense).
You can get into the same trouble after a divorce by using your IRA funds to meet divorce-related financial commitments to your ex. In either situation, the other party gets a tax-free cash windfall, while all you get is a bill from the IRS.
The moral: Make sure your divorce documents specify that any and all transfers of your IRA funds to your spouse or ex-spouse are pursuant to the divorce settlement and intended to be tax-free under Section 408(d)(6) of the Internal Revenue Code. Also make sure the transfer is accomplished via a "direct" or "trustee-to-trustee" rollover from your IRA to an IRA set up for the other party. If you follow this advice, the transfer doesn't cost you any taxes. The other party will owe Uncle Sam when money is subsequently withdrawn from the rollover IRA. Fair is fair.
IRA to IRA Rollovers (Including the Roth)
If you are simply transferring funds from one IRA to another, as in a rollover to a Roth IRA, there is no 20% withholding to worry about. So a withdrawal check can be made out in your name with no adverse tax consequences as long as the other IRA has not received any other rollovers within 365 days. (Again, "direct" rollovers into that account don't count for purposes of the 365-day waiting period rule.)
However, you must still get the money into the other IRA within 60 days, or you will be taxed on the withdrawal.