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Options for Re-investing Retirement Plan Contributions

Are you thinking about changing jobs or retiring? If you expect to receive a distribution from you employer’s pension, profit sharing, 401(k), 403(B) or other tax-deferred retirement plan, here is some important information you need to know:

  • Your employer is required by law to automatically withhold 20 percent of your distribution for income tax purposes unless you elect to roll over your distributions, including those due to termination of employment. (Certain distributions are exempt from the 20 percent tax withholding – consult your tax adviser for more information.)

  • If you take your distribution before you reach age 59 ½ or as a result of separating from service before age 55, you might be subject to an additional 10 percent tax penalty for an early withdrawal. Since your qualified retirement plan distribution could represent the largest sum of money you will ever receive at one time, it is important to evaluate the distribution options available to you. Although the number of distribution alternatives varies depending on the terms of the specific qualified plan, you generally have the following two choices: a distribution made payable to you, or a direct rollover to an IRA or other qualified plan.

Distribution made payable

If you decide that you need the money now, and the distribution is made payable to you, you are subject to the 20 percent tax withholding. This means that you would receive a check for 80 percent of the account balance. The withholding taxes would be sent to the IRS and credited towards your federal income taxes. After you receive your distribution, if you change your mind and decide that you would like to roll it over into an IRA or an eligible qualified plan of your new employer, the following options are available.

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

  • Roll over 100 percent of the amount of the distribution within 60 days by contributing cash to replace the 20 percent that was withheld. That 20 percent would still be credited towards your federal income taxes.

Direct rollovers

Rather than directly receiving the distribution, you have the option to elect to have all or part of your eligible distribution rolled over from your company’s retirement plan to an IRA, or to your new employer’s plan. Direct rollovers have two distinct advantages over taking distributions directly:

  • The avoidance of what could be a hefty, immediate tax burden, allowing you to invest more money now.

  • The opportunity for faster accumulation of your money over time through tax-deferred growth.

Direct rollover to an IRA

A Rollover IRA is a traditional IRA that has been established for the sole purpose of receiving a distribution from a qualified plan. After receiving written notice from your employer describing your options, you will be given time to establish a Rollover IRA with the financial institution of your choice and to give your employer instructions for completing the direct rollover. You should contact the institution where your IRA will be established to obtain the necessary paperwork and instructions on forwarding the distribution. In some cases, your company will be able to directly transfer the assets to the IRA. In other cases, the company will prepare a check.

Be sure to instruct the company to make the check payable to the IRA custodian and not to you in order to avoid the 20 percent withholding. When you complete a direct rollover, your employer will report the direct rollover distribution to the IRS on Form 1099-R and your IRA trustee or custodian will report the offsetting direct rollover contribution on Form 5498.

Direct rollover to another qualified retirement plan

If your distribution is the result of your changing jobs and your new employer has a qualified retirement plan, ask the administrator of the plan if rollover deposits are accepted. If they are, you can have your former employer make the check payable to the new employer’s plan trustee. If the plan does not accept rollover deposits, you can initiate a direct rollover to an IRA as described above.

Making your decision

The rules regarding distributions can be complex and contain many other conditions and exceptions that could not be discussed in this article. The distribution option you choose likely will depend on your current financial situation and your future needs and goals. Consult a financial advisor, as well as tax and legal advisors to help you sort through the distribution options, and assist you in developing an investment strategy to meet your retirement objectives.

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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 updated on Thursday, December 18, 2008 11:10 AM

 
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