You’ve changed jobs (or lost a job), and you want to move your retirement plan money from your former employer to your IRA. If that money rolls over directly from your employer’s plan to your IRA (typically called a “direct rollover”), then there is no tax penalty or tax reporting. That’s usually the best route to go: short, sweet, clean.
But what if you want the retirement plan money to come to you first, and then you’ll take responsibility for sending it along to your IRA? After all, the IRS does allow this process–it’s called a 60-day rollover. As long as you get that retirement plan money into an IRA within 60 days of receipt, there’s no 10% tax penalty nor is any income tax due. There will be some tax reporting (1099-R forms, which report rollovers), which is kind of a pain.
But the biggest pain is the automatic 20% withholding your former employer must withhold. It’s not a tax penalty per se, but rather a tax down payment on the assumption that you will not be rolling your employer plan money to an IRA. It works like this:
Bob’s employer retirement plan account balance is $50,000. On February 1, he receives a check from his former employer’s retirement plan for the amount of his rollover, which is only $40,000. Bob, who is age 40, deposits the check into his bank account and wonders where the missing $10,000 went. It turns out that (by law) his former employer sent $10,000 to the IRS on his behalf to go toward this year’s taxes. Now Bob has 60 days to come up with $10,000 out of his own pocket to add to the $40,000 he wants to send to his IRA.
But Bob doesn’t have an extra $10,000 lying around (because he lost his job, let’s say), so he sends only $40,000 to his IRA in early March (within 60 days). The IRS assumes the missing $10,000 has been spent by Bob. Because Bob is under age 59 1/2, he gets hit with a 10% early withdrawal penalty. And that entire $10,000 is fully taxable to him as ordinary income (just like he received a paycheck). The only good news is that Bob doesn’t have to pay his tax and penalty until April of next year when he files his tax return. At that point, he can claim that $10,000 sent to the IRS by his employer as tax paid on his return for this year. But Bob still got hit by that 10% early withdrawal penalty on the $10,000, so he owes the IRS an extra $1,000–all because Bob didn’t have an extra 10 grand at the time of the rollover.
On the other hand, let’s assume Bob did have the $10,000 available from his own pocket at the time of the rollover, so he sent in the full $50,000 to his IRA within 60 days. What happens to the $10,000 withheld by Bob’s employer and sent to the IRS? He will claim it as tax paid on his tax return he files next April for this year, and most likely Bob will get a lot of it back at that time as a bigger-than-normal refund.
But seriously, who wants to go through this hassle? Coming up with the extra money to make up the 20% withheld, a 60-day deadline, the extra tax reporting, a possible 10% penalty…. It’s much easier and more cost-effective to nearly always have your retirement plan money go directly to an IRA.
Next time: another way to maximize your retirement readiness by avoiding a common costly mistake made with employer stock going to an IRA.