I recently told you about a U.S. Tax Court case (see part 1)  about what happens if you withdraw early on your retirement money. Se  “Understanding IRA Rollovers”. What happened in Kim’s case illustrates why you should consider seeking professional tax
advice whenever you are contemplating a significant financial move. The IRA rollover rules seem simple (see information below for the basics), but many taxpayers fall into traps when leaving their jobs. With proper advance planning, it is often possible to achieve your objectives in a way that minimizes taxes. Without proper planning, the tax results may be dire, and you may not be able to improve those results after the fact.

Consult with your tax adviser if you have questions or want assistance to ensure a smooth, tax-free transaction.

IRA Rollover Rules

After retiring or leaving a job, one big question might be: What should you do with the money in qualified retirement plan accounts with your former employer? These accounts include 401(k)s, profit-sharing plans, and stock bonus plans. The standard advice is to roll everything over into an IRA. That advice generally makes sense because you can take over management of the funds while continuing to defer taxes on income generated. However, the standard advice isn’t best in all situations.

“Direct” Rollover

If you decide to go this route, arrange for a “direct” or “trustee-to-trustee” rollover from the qualified retirement plan into your IRA. In other words, the check from the company plan should be made out to the trustee or custodian of your rollover IRA. You may be able to arrange for a wire transfer directly into the rollover IRA.

Note: While the IRA must be set up in advance to receive the upcoming rollover contribution, the account can be empty prior to the transaction.

Why is a direct rollover important? If you receive a retirement plan distribution check payable to you personally, 20% of the taxable amount of the distribution must be withheld for federal income taxes. You are left with a check for only 80% to deposit into the account, although you are responsible for depositing 100%.

You have 60 days to come up with the other 20% and deposit it into the IRA. Otherwise, you will owe income tax on that 20%, plus a 10% early withdrawal penalty tax generally applies if you are under age 55 when leaving your job.

Of course, if you fail to deposit the 20%, you will still be entitled to a federal income tax refund because the withholding will exceed the actual tax (and 10% penalty if applicable) that you owe. However, you won’t get that refund until after filing a tax return for the year the withholding occurs. That could be many months later. Even worse, your rollover IRA balance will be 20% smaller,
which means lost tax deferral benefits.

Note: The mandatory 20% federal income tax withholding rule doesn’t apply if you are rolling money from one IRA to another. It only applies to distributions from a qualified retirement plan, such as a 401(k) plan. However, you must always meet the 60-day rule, even for an IRA-to-IRA rollover.

Obey the 60-Day Rule

Another pitfall is failing to meet the 60-day rule. Specifically, you must deposit the retirement account distribution into an IRA within 60 days to achieve a tax-free rollover. The 60-day period starts on the day after the funds are received from the retirement plan and ends on the day you deposit them into an IRA.

Note: Unlike many IRS deadlines, you don’t get extra time if the end of the 60-day period occurs on a weekend or holiday.

In fact, the only instance when failing to meet the 60-day rule isn’t disastrous to your tax planning objectives is if the failure is due to “circumstances beyond your control.” Even in these cases, you have to prove to the IRS that you are blameless.