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Distributions from Your Retirement Plan

Advantages and Disadvantages of Rollover to a Traditional IRA

Advantages:

  • No current taxes due at distribution if a direct rollover.
  • Assets are invested in a tax-deferred environment.
  • Opportunity to invest the cash that would otherwise go to taxes until ultimate distribution.
  • You may convert the traditional IRA to a Roth IRA (however there are potential taxes due from conversion).

Disadvantages:

  • The tax rate on amounts distributed from the IRA may be higher depending on your tax bracket during distribution years.

IMPORTANT NOTE: 

: The Coronavirus Aid, Relief, and Economic Security (CARES) Act enabled any taxpayer with an Required Minimum Distributions (RMD) due in 2020 from a defined contribution retirement plan, including a 401(k) plan, 403(b) plan, or an IRA, to skip those RMDs this year. This includes anyone who turned age 70½ in 2019 and would have had to take their first RMD by April 1, 2020, under the law in effect before the enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, enacted on Dec. 20, 2019, as Division O of the Further Consolidated Appropriations Act, 2020, P.L. 116-94. The waiver of RMDs does not apply to defined benefit plans.

In addition to the rollover opportunity, an IRA owner or beneficiary who has already received a distribution from an IRA of an amount that would have been an RMD in 2020 can repay the distribution to the IRA by Aug. 31, 2020. This repayment is also not subject to the one rollover per 12-month period limitation and the restriction on rollovers for inherited IRAs.

Direct vs. Indirect Rollovers

When you move money from one type of retirement account to a different type of retirement account, that's a rollover. But there are two different kinds of rollovers with very different tax implications:

• A direct rollover is where your money is transferred directly from one retirement account to another. No money is withheld for taxes.
• An indirect rollover is where you essentially cash out your old retirement plan and re-invest the funds in a new plan in 60 days or less. In this case, 10 to 20 percent of the money is withheld for taxes.

Direct rollovers are pretty simple. In most cases, your retirement account administrator sends the money directly to your new account and you don't have to do a thing. In some cases, your account administrator sends you a check made out to the new IRA "for the benefit of" you [source: Lewis]. The check will read something like "Touchstone Investment IRA FBO John Smith." Your responsibility is to mail the check to the new IRA. Since the money is never technically in your hands -- you can't cash an FBO check -- the IRS does not treat it as income and no taxes are withheld.

Indirect rollovers are a different story. With an indirect rollover, your administrator cashes out your retirement account and sends you a personal check called a rollover distribution. But the check you receive will not be for the full amount in your retirement account. If you are rolling over from an IRA, 10 percent will be withheld. If you are rolling over from a 401(k) or other qualified employee plan, your administrator will withhold 20 percent [source: IRS].

That's because the IRS requires administrators to withhold money from rollover distributions to help cover the taxes that may be owed on that money. Technically, rollover distributions are considered taxable income. Even worse, if you take a rollover distribution before age 59½, you must pay a 10 percent early withdrawal penalty.

The good news is if you re-invest the funds in a new retirement account within 60 days, you won't owe any taxes or penalties. Here's the trick, though. The IRS requires that you re-invest the exact amount that was in the old retirement account, including any money that was withheld. So if your 401(k) was worth $10,000, and the administrator sent you a check for $8,000 (the total minus 20 percent), you will need to come up with $2,000 of your own money to re-invest the full $10,000 in a new IRA [source: IRS]. You'll get back the withheld $2,000 in the form of a tax credit.

Because of the potential tax implications of indirect rollovers, most investors opt for direct rollovers.

Retirement Account Transfers
Remember, in order to transfer money from one retirement account to another, both accounts need to be of the same type. For example, you can transfer money from a traditional IRA to a traditional IRA, or a 401(k) to a 401(k), but if you lose your job and want to consolidate your 401(k) savings into an IRA, that requires a rollover, not a transfer.

Transfers are sometimes called trustee-to-trustee or custodian-to-custodian transfers because the money is sent directly from the administrator of one retirement account to the administrator of another.

One of the biggest differences between transfers and rollovers has to do with taxes. As we explained, with indirect rollovers, the IRS requires that a percentage of your funds be withheld for tax purposes. And if you don't re-invest the rollover distribution within 60 days, you have to pay income taxes on the funds, plus an early withdrawal penalty if you are younger than 59½. When you conduct a transfer, however, the money is never in your hands, so the IRS has no right to withhold taxes or charge early withdrawal penalties.

Even better, the IRS doesn't have to know about retirement account transfers. With rollovers -- both direct and indirect -- the IRS requires taxpayers to report the rollover distribution on their 1040 income tax form, even if no taxes are owed. That's not the case with transfers. You can move large sums of money from one IRA to another and you don't even have to report the transfer.

There are also no restrictions on how many transfers you can do in the same year. With rollovers, you are limited to one rollover every 365 days, but you are free to make as many IRA-to-IRA or 401(k) to 401(k) transfers as you want.

Rollover or Transfer: Which Makes Sense?
In the majority of cases, direct rollovers and transfers make the most sense when moving money between retirement accounts. It's all about shielding your money from income taxes and early withdrawal penalties. With a trustee-to-trustee transfer or a direct rollover of 401(k) funds, the IRS can't touch your retirement money. But with an indirect rollover, there is much more potential for making a mistake that could cost you thousands of dollars in income tax plus a 10 percent early withdrawal penalty.

But no single investment strategy is right for everyone. Some investors might like the idea of getting their hands on a large chunk of cash, even if it's only for 60 days. Maybe you have an exciting short-term investment opportunity with the potential for large returns. If you choose the indirect rollover option, your 401(k) administrator will cut you a check with a promise that you'll re-invest the full amount in a new IRA in 60 days or less. In the mean time, you are free to use that money as you please. The risk, of course, is that you could lose the money. If you can't come up with the full amount in 60 days, you'll owe income tax plus penalties.

Another option is to do nothing. No rollover, no transfer, just let the money stay in your old 401(k). If you have $5,000 or more in the account, you usually don't have to contact the administrator. But if you have less than $5,000, some 401(k) plans automatically liquidate the funds, so you have to act quickly to secure them.

 

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