IRAs are tax-smart investments offering tax-deferred and tax-free investment earnings, among other benefits. The tax laws provide these benefits and allow IRA owners great flexibility in selecting investments and moving money between their accounts. But these laws also impose rules that must be followed to preserve the benefits and avoid taxation. Here are some tips on how to avoid a taxable transaction when you’re moving workplace retirement plan or IRA savings.
What Not To Do
Don’t ask your former employer to send you a check
If you have an account in a former employer’s retirement plan and request a withdrawal payable to yourself, the plan administrator must withhold 20% of the amount you take out of the plan. The plan will send that 20% to the IRS as a pre-payment of your tax liability on the withdrawal. Even if you deposit the amount you received into an IRA within 60 days, you must include that 20% in your taxable income for the year – even though you never received it. And it is subject to the 10% early distribution tax if you were younger than 55 when you left your employer.
Don’t roll over assets that aren’t eligible to be rolled over
Most distributions from a retirement plan are eligible for rollover, but certain ones are not. Annual required minimum distributions (RMDs) started at age 72 are not permitted to be rolled over. You also cannot roll over an amount that is distributed as an excess contribution, a loan treated as a distribution, a hardship distribution, a series of substantially equal payments, or dividends on employer securities. If you do, and it exceeds the amount you are eligible to contribute to an IRA for the year, it will be treated as an excess in the IRA.
Don’t try to roll over more than one IRA distribution every 12 months
To prevent IRA owners from taking “short-term loans” from their IRAs, the tax laws limit how frequently you may roll over assets between IRAs. You may only roll over one IRA withdrawal to another IRA every 12 months, regardless of how many IRAs you have. There are no limits to how often you can transfer directly between IRAs, however.
Don’t mix up the tax status of your savings
Most employer plan assets are not taxed until withdrawn – including salary deferrals, employer contributions, and investment earnings. But any after-tax or Roth contributions in your plan account are tax-free, so be sure those assets get rolled over to a Roth IRA to maintain their tax-free status. You can request that your employer’s plan send your pre-tax assets to your Traditional IRA and the after-tax and Roth assets to your Roth IRA.
Similarly, moving assets from one IRA to another IRA of the same type will avoid any tax consequences – this means moving assets from a Traditional IRA to a Traditional IRA, a SIMPLE IRA to a SIMPLE IRA, and a Roth IRA to a Roth IRA. Moving money or assets between a Roth IRA and a Traditional IRA will almost always have tax consequences. For example, an IRA owner may choose to move assets from a Traditional IRA to a Roth IRA to recharacterize the tax status of a current-year contribution or to convert pre-tax assets to a Roth IRA, which is a taxable transaction.
Don’t roll over cash if you took an in-kind distribution
If you distribute property or an alternative investment from an IRA without liquidating it and you want to put it in another IRA, you may roll over only that same property. You generally cannot sell the property or stock outside of the IRA and roll over the cash proceeds.
What To Do Instead
Ask for a direct rollover or a transfer
Be sure to ask your former employer’s plan for a “direct rollover” to your IRA. There is no tax withholding on a direct rollover and your assets should travel directly from your employer’s plan to your IRA, ensuring a tax-free transaction. Similarly, request a direct transfer from one IRA custodian to another IRA custodian rather than taking payment to yourself so you don’t use up your one IRA rollover for the year or trigger any unintended tax consequences.
Make sure you have an IRA set up first
When you request a direct rollover or transfer, you’ll need to provide the receiving IRA custodian’s name, address, and deposit instructions to the current custodian or plan administrator, so they know where to send the money.
If you received a distribution check, make a 60-day rollover
If you have already requested a check payable to you from a former employer’s retirement plan, you may still be able to roll over your savings to an IRA tax-free if you can complete the rollover within 60 days of the day after you received the check. If you deposit 100% of the amount that was distributed from the plan (including the 20% that was withheld and sent to the IRS), you will not be taxed on the distribution. This means you must produce the cash to cover the 20% that was withheld and deposit it into the IRA with the rest of the distribution amount. You may receive some or all of the withholding as a tax refund when you file your tax return for the year.
Ask for Help
IRA custodians, your financial advisor, and your plan administrator want to help you preserve your tax-deferred retirement savings. If you have questions regarding the tax status of your STRATA account or IRA rollovers, contact our self-directed IRA experts for more information.