Understanding IRA Rollover Rules

Your grandfather may have worked for the same company from the day he graduated high school until his retirement at age 65, but today, most of us will work for several different employers over the course of a career. By the time a current Baby Boomer retires, they’re likely to have held 12 different jobs.

With all of those jobs comes a patchwork of retirement benefits. No two employer packages are the same, and each time you switch jobs, you’ll have to decide what to do with that 401(k) account moving forward. Fortunately, you don’t have to keep track of a dozen different accounts — rollovers let you combine your retirement money to make managing it much easier.

But there are rules to follow. Here’s what you need to know.

What is an IRA Rollover?

An IRA rollover is the process of shifting funds from one type of retirement account to another. For example, a traditional 401(k), 403(b), or TSP is tax-advantaged, and you only have to pay taxes when you take money out of the account.

But technically, closing an old 401(k) would look exactly like taking all the money out of it. So to make sure that everyone follows the rules and pays the correct amount of taxes on the money, you are required to complete some paperwork that proves you actually put all the money from one retirement account directly into another one. This is the rollover process.

The whole point of a rollover is to avoid having to pay taxes on your retirement money just for moving it around. It also means you avoid paying a 10% penalty on that money if you are under age 59½.

A quick technical note: An IRA rollover describes the process of moving money from one type of retirement account to a different type of account. For example, you may wish to rollover an old 401(k) into a personal IRA when you retire or switch jobs so that you have greater control over your investment options (instead of being limited to the choices provided by your employer). An IRA transfer, on the other hand, is the process of moving money between two retirement accounts of the same type. For example, you could transfer the money from one 403(b) to another when you change jobs. Both processes are designed to shelter you from any tax consequences or penalties, provided you follow the rules.

Rules for Tax-Free Rollovers

First, you’ll need to open a personal IRA account if you don’t already have one. Your money needs somewhere to go when you roll it over, so this is the first step. When you do this, decide if you want a traditional or a Roth IRA. If your goal is to pay no taxes, you’ll need to choose a traditional IRA: Money moved from a traditional 401(k) to a Roth IRA will be taxed at your regular income rate, which could leave you with a much bigger tax bill than you anticipated.

Next, you’ll initiate the rollover. There are three ways to do this:

• Trustee to Trustee Transfer: Also known as an in-kind transfer, this can be done if you are moving money from one type of account to the same type of account with a different bank. It’s the easiest to accomplish, since your current bank will send the money directly to the new one. There’s no extra reporting to the IRS and no withholding of taxes.
• Direct Rollover: In this type of rollover, your current retirement plan administrator will send your money directly to your new plan. In some cases, you might get a physical check made out to your new bank and have to do the mailing yourself. But since your name is not on the check, no taxes are withheld, and the process is much easier. At the end of the year, you’ll receive a 1099-R form to report on your taxes, but you will not owe any taxes as long as the amount on the form matches the amount you deposited into your new retirement account.
• 60-Day Rollover: With this type of rollover, your plan administrator sends you a check for your funds. This check is in your name, and you have 60 days to deposit it into a new account to avoid taxes and penalties. If you’re moving funds from a 401(k), your plan administrator is required to withhold 20% of the amount for taxes (though you will eventually get this back). You’ll receive a 1099-R form to report the transaction to the IRS when you file your income taxes.

Rollover Mistakes to Avoid

Most rollovers go off without a hitch, but you do need to be careful about the paperwork. Avoid these mistakes so you don’t get stuck with a big tax bill:

• Choosing a 60-Day Rollover: If a trustee to trustee transfer or direct rollover is available to you, take it! It’s the best way to avoid tax withholding or an accidental bill from the IRS if you miss the 60-day deadline.
• Missing the 60-Day Rollover Window: If you must have the check sent to you in your name, send it to your new plan administrator for deposit right away. Some people wish to borrow from themselves during this 60-day period (i.e., temporarily using a portion of the IRA funds before completing the rollover), but this is only appropriate if you are absolutely certain you can pay the full amount into your new retirement account by the deadline.
• Rolling Over Into a Roth Without Planning for Taxes: You can roll funds into a Roth IRA, but you’ll have to pay taxes on the full amount at your regular income rate next April. This can be a solid strategy for retirement overall, but you’ll need to plan ahead for the bigger tax bill to avoid a shock.
• Failing to Report Your 1099-R: You should receive this form automatically from your plan administrator, so plan to contact them if you don’t. You’ll need to remember to report the amount on the form as miscellaneous income on your taxes — though if all the numbers match up, you won’t owe anything.

The Bottom Line

Consolidating your retirement accounts into one easily managed IRA makes a lot of sense for most people. As long as you are careful to follow the rollover rules, you can avoid taxes and penalties as you get your financial house in order. And if you need more advice about how to make sure you’re saving enough, we’re here for you! Contact us today to get started on the right retirement plan for you.