Common IRA rollover tax traps — and how to avoid them

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If you have quit your job, making a transfer from the IRA of the balance to your company’s retirement plan is usually a smart tax move. A transfer allows you to continue to defer taxes on the amount you transfer. But our beloved Congress set some federal income tax traps for the unwary. Do not be among the unwary. Here’s how to avoid the inconvenience.

1. Arrange the direct transfer of the business plan to your IRA

After you leave your former job, you will probably want to transfer the money from the qualified retirement plan (or plans) from your former employer to an IRA. This way, you will gain full control of your funds while you continue to defer taxes. But there is a tax trap to be avoided. Dodge it by organizing a direct transfer from trustee to trustee of the plan to your IRA. In other words, the plan check or EFT should go directly to the trustee or custodian of your IRA. Although you must have an IRA set up and waiting to receive the transfer, your account may be empty sooner.

Here’s why making a direct transfer is key: If you receive a check for a retirement plan that pays you in person or a distribution that goes to a personal account through an EFT, 20% of the amount must be withheld. taxable of payment for federal expenses. Income tax. You will then have 60 days to find the 20% “missing” and enter it into your IRA. Otherwise, you cannot get a completely tax-free transfer. You will owe the 20% income tax and maybe the dreaded 10% early retirement penalty tax even if you are under 55 years old. Here is an example.

Example: After you quit your job at age 50, you’ll have to pay $ 300,000 from the company’s 401 (k) plan. You want to transfer the full amount, but you cannot arrange a direct transfer. Therefore, you will receive an EFT in your personal account in 2022. Surprise. The EFT is only $ 240,000. The “missing” $ 60,000 went to the U.S. Treasury for mandatory withholding of 20% federal income tax. Wow!

Now, somehow, you have to accumulate $ 60,000 and enter them into your IRA within 60 days to get a completely tax-free transfer. Say you get it. Great. But you can only get back the $ 60,000 that went to the feds by making reduced federal income tax payments for the rest of 2022 or claiming a refund when you file your 2022 return next year. Either way, it will take a while to get the $ 60,000 back.

If you fail to recover the $ 60,000 “missing” and incorporate it into your IRA within 60 days, you will have to pay federal income tax on the $ 60,000 (because it was not transferred) plus you will likely have to owe another $ 6,000 for the 10% Early Withdrawal Penalty Tax (because you’re under 55). Not good.

What to do: Avoid all the hassle by arranging a $ 300,000 direct transfer to your IRA.

2. In this situation, avoid turning

If you are 55 or older when you receive a qualified retirement plan payment from your former employer, you will not have to pay the 10% early withdrawal penalty tax on the money you choose to keep in your hands when not transferring or transferring. the amount. in an IRA. You will owe a federal income tax and perhaps a state tax on the amount you keep out of your IRA. But at least dodge the 10% penalty tax.

However, if you roll up or transfer the money to your IRA and then have to withdraw part or all of that amount before the age of 59 and a half, you will generally have to pay the early withdrawal penalty of 10% plus of income tax. Ai.

What to do: Plan ahead to avoid being hit unnecessarily with the 10% penalty. If you need some of the money you’re thinking of reversing, don’t spin it.

3. You may not want to transfer the company shares they have to your retirement plan account

In a previous column, I explained the special federal income tax rules that may dictate against the renewal of valued employer shares that remain in your company’s retirement plan and are distributed to you after you resign. . It is best to put these company shares in a taxable brokerage company account. For more information, see this Tax Guy column above.

The bottom line

You might think that arranging the tax-free transfer of the balances of the employer’s retirement plan to IRAs would be a relatively infallible task. But our beloved Congress has dictated the opposite, for inexplicable reasons that illustrate why you don’t want the government to control your life. That’s why I hear about failed attempts at renewal, and unnecessary fiscal impacts, year after year with no end in sight. Please read the wisdom disclosed here carefully and seek advice from a tax professional if you have questions about transferring significant amounts.

Sidebar: Beware of the weird rule of one IRA-rollover per year

After you have transferred your company retirement plan balances to your IRA, you may want to arrange one or more IRA to IRA transfers for any reason. For example, you might want to set up separate IRAs for each of your beneficiaries and then transfer an existing IRA balance to fund new accounts.

The general rule is that you can withdraw all or part of an IRA balance and then return it to the same IRA or another tax-free IRA, as long as you return the money within 60 days. Great, but there is a tax trap.

You can only make one of these IRA to IRA changes in a 12 month period. If you make two or more withdrawals during this period, the additional withdrawals will count as taxable distributions that may result in a 10% income tax and early retirement penalty penalty if you are under 59 ½ years old. Why this strange limitation? Who knows, because it serves no logical fiscal policy purpose that it can detect.

Fortunately, you can dodge the trap of a roll-per-year IRA by moving money from one IRA to another using direct transfers from trustee to trustee that never pass through your hands. Interestingly, these transfers do not count as a transfer for the purposes of limiting one IRA-rollover per year. Why not? Again, who knows? (Source: IRS 78-406 Revenue Regulations.)

Another useful loophole says that transferring a distribution from a qualified retirement plan, such as a 401 (k) plan, to your IRA does not count as a transfer for the purposes of the IRA-rollover-per-limitation. year. Imagine. (Source: IRS Regulation 1,402 (c) -2, Q&A-16.)

What to do: Take advantage of these gaps for any IRA to IRA transfer. That way, you’ll never have to worry about cheating on an IRA-rollover-per-year.

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