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Direct rollovers allow avoidance of 20 percent tax withholding. . .

If you expect to receive a distribution from your employer’s pension, profit sharing or 401(k) plan, there is some important information you should know.
 
Without understanding lump sum retirement plan distributions, you might have to hand a portion of your hard-earned retirement money in unnecessary taxes and penalties to the IRS.
 
Your employer is required by law to automatically withhold 20 percent of the distributions unless you elect to roll over your distribution directly into an eligible retirement plan, such as a individual retirement account (IRA) or a new employer’s plan.  The law impacts almost all distributions, including those due to termination of employment.

Distributions made payable 

Generally, a plan distribution that is paid directly to you may be subject to the 20 percent tax withholding.  This means that you would take home only 80 percent of your total plan distribution.  The 20 percent withheld would be sent to the IRS and credited toward your federal income taxes.  Furthermore, if you take a distribution before age 591/2, you may be subject to an additional 10 percent tax penalty for an early withdrawal. 
 
After you receive your distribution, if you decide that you would like to roll it over into another retirement plan, the following options are available:

  • You may roll over the 80 percent that you received within 60 days.  The remaining 20 percent withheld would be considered taxable income.

  • You may roll over 100 percent of the amount of the distribution within 60 days by coming up with cash to replace the 20 percent withheld which would be credited toward your current years tax liability.

It’s easier however, to just avoid the 20 percent tax withholding by arranging for a direct rollover with your employer. 
 
Rather than receiving the distribution directly, you have the option to elect to have all or part of your eligible distribution rolled over from your company’s retirement plan to a traditional IRA, or to your new employer’s plan.
 
A rollover IRA, also known as a 'conduit' IRA, is established (at a financial institution of your choice) for the sole purpose of receiving an eligible distribution from a qualified plan.  A rollover IRA is designed so that you can subsequently roll the money over into a new employer’s qualified retirement plan.  You can, of course, leave the money in the rollover IRA and continue to benefit from tax-deferred growth and the wide range of investment choices typically available.
 
If, however, you wish to maintain the option of being able to eventually roll the assets into a new employer’s plan, you may not make additional IRA contributions to the conduit/rollover IRA.
 
While, in past years the rollover IRA was only permitted to hold those assets received from a former employer’s qualified retirement plan as well as the gains and earnings on those assets, more recent legislation has relaxed that restriction thus permitting various types of contributions to be deposited and comingled in this retirement plan 'holding' account.

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Information is provided for review and consideration only. Please consult legal and tax advisors for practical advice pertaining to your business and personal situations.

This page was last reviewed and/or updated on Sunday, February 28, 2010 10:55 PM

 
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