by Peter Klenk, Esq.

You likely participate in some kind of retirement plan.These plans vary, they are complex and the rules governing them change often. In this short article I will attempt to explain the general rules and concepts of the rollover of a qualified plan.

The money in your retirement account is pre-tax dollars; dollarson which you have yet to pay income tax. The advantage of a 401(k) or other plan is that you are putting your money… and some of the IRS’ money… into an account to invest for retirement. As long as it stays in the account both your money and the IRS’ money can grow. When the money is taken out of the account it is no longer protected and the IRS expects you to report the withdrawal as income on that year’s income tax return. A rollover is when a person takes a distribution from one tax-deferred retirement plan (401, IRA, governmental 457(b) or 403(b)) and moves that distribution into another eligible retirement plan. If the distribution is moved into an IRA or into a new employer’s plan,the primary benefit is the continuation of income tax deferral.

Movement from one plan to another without paying income taxes cannot be done at any time; there must be a specific “Triggering Event.” Triggering events arespecific times the IRS has deemed acceptable to allow participants of an employer-sponsored retirement plan to take tax-free distributions from the plan. Typical examples of triggering events are separation from service (quitting/fired), attainment of normal retirement age (not early retirement), death, disability or termination of the plan by the employer. A participant must meet only one of these triggering events.

To avoid income tax, the money taken from the retirement plan must be transferred into another “eligible retirement plan.” An eligible retirement plan can be an IRA or another employer-sponsored retirement plan. Check with person who administrates the plan into which you hope to transfer the funds, as some plans do not allow for the acceptance of funds from other eligible retirement plans.

Rollovers can be one of two types;direct and indirect.

Direct Rollovers are when the former employer’s plan sends the retirement assets directly into the new eligible retirement plan or IRA. The taxpayer never has the money in his accounts nor is a check ever made payable tohis name. There is no “constructive receipt” of the assets, meaning the check is not made payable to the taxpayer and then deposited into the new plan. Because of the direct transfer from an eligible plan into a new eligible plan the assets are not reported as taxable (avoiding a potential 10% early distribution penalty), but the funds will be reported to the IRS (via an IRS Form 1099-R) but reported on the form as non-taxable. The new plan then generates an offsetting Form 5498. There is also no mandatory 20% federal income tax withholding by the initial plan administrator.

Direct Rollover (transfer from plan-to-plan) is often confused with a “Transfer”. A Transfer is when plan assets are moved from one investment in the plan to a new investment. The same plan is kept, only the investments are changed. Transfers are nontaxable and non-reportable, so no 1099-R is generated.

Indirect Rollovers exist when the previous plan administrator sends the retirement plan assets directly to the employee. Because these tax-deferred assets are sent to the employee and are no longer sheltered in a qualified plan, unless the employee makes a specific election to avoid withholding the plan administrator is required to withhold 20% of the gross distribution amount. Because the check is in the employee’s name, the employee now has “constructive receipt” of the funds and without taking the correct steps the employee must report the distribution as income and perhaps pay a 10% early distribution penalty. To avoid income taxation and the penalty, the taxpayer must roll the funds into an eligible planwithin 60 days. Further, in order to avoid the 10% penalty the full amount of the distribution must be put into the new plan including the 20% withheld by the former plan administrator. This means the employee must make up the amount that was withheld out of his or her own funds and then file for a refund for the withheld amount. This can be very burdensome.

Some articles have been written about the “IRA Loan”, where it is suggested that the owners of IRAs take Indirect Rollovers from an IRA, electing to have no withholding, and then use the funds for 60 days prior to depositing them back into a new eligible plan. The IRS is familiar with such “loans”, and the rules limit one rollover per IRA per 12-month period. The problem with such loans is that often the taxpayer is not able to deposit the money into the new plan in the 60-day period and the IRS rarely forgives the lapse of time. Though the technique works, it is a dangerous plan with heavy financial consequences, because the taxpayer is forced to recognize the funds as income, has to pay the 10% penalty and has lost the tax deferred status of the funds.

I hope that you have found this short article helpful! If you have any further questions please feel free to contact your financial professional or myself.