Nearly 200 companies have made significant changes to their pension plans over the past 10 years. Plan terminations, freezes and benefit formula adjustments are some of the changes companies are making to control costs. This situation was created by the high cost of maintaining these pensions due mainly to our longer life expectancy.
Employees with frozen pensions will need to wait until retirement age to roll over their pension unless the employer offers an early buyout. A terminated plan, on the other hand, generally provides a rollover option to employees right away. Many companies are closing out their pension plans, giving workers the opportunity to roll them over to an IRA or another plan. Done correctly, rollovers are tax neutral; done incorrectly, rollovers can create significant tax liabilities.
Rolling over a company pension plan to an IRA is a simple procedure with fairly basic rules. You generally avoid paying taxes on the distribution at the time of the rollover and your money continues to grow tax-deferred. The funds will be taxable if you don’t roll them over and you may also be subject to additional tax penalties.
Follow these steps when you receive a buyout offer from your pension plan.
Step 1: Consider the offer carefully before accepting
This is a risk transfer from the employer to the employee. The pension plan currently has the risk of making the promised payments at retirement for the rest of your life. Accepting the buyout transfers investment risk to you, the employee. This is a very individual decision and depends on your personal circumstances, such as your health and expected longevity, other guaranteed income streams in retirement, your investment assets, your comfort and ability to invest a lump sum, your desire to leave a portion of your retirement funds to your heirs, and your particular federal income tax circumstances. You should consult a financial adviser who specializes in retirement to help you determine the best option.
Step 2: Verify the lump sum offer had been calculated correctly
Contact the company’s benefits officer and ask for a summary plan description. This summary will explain in general how the company’s pension is calculated. Request a personal statement of benefits which will tell you specifically how your benefit amount has been calculated. This statement may be included in your lump sum offer. Don’t accept an offer until you’ve verified the amount is correct.
Step 3: Choose the type of rollover
Rollovers from a pension can be done one of two ways:
- Direct rollover – The plan administrator makes the payment directly to another IRA. The plan may send the distribution in the form of a check to you but made payable to your new account. No taxes will be withheld from your transfer amount.
– OR – - 60-day rollover – The distribution is paid directly to you. You must deposit all of it in an IRA within 60 days. A retirement plan distribution paid to you is subject to mandatory tax withholding of 20%, even if you intend to roll it over later. You’ll have to use other funds to roll over the full amount of the distribution. For example: If you elect to have your $100,000 lump sum paid directly to you, your plan must withhold $20,000 and will only send you $80,000. In order to avoid taxes, you would need to come up with the withheld $20,000 to invest in your IRA within the 60 day period. If you do not, that portion withheld will be included in your income and taxed. This could send you into a higher tax bracket. You might also face the 10% early distribution penalty. Remember that the $20,000 that was withheld will add to your total withholdings so you would probably get some of it back when you file taxes.
Anyone who intends to roll over the entire distribution to an IRA should elect the direct rollover to avoid the 20% mandatory withholding.
Step 4: Establish an IRA with a custodian if you don’t already have one
An IRA custodian is a financial institution (bank, brokerage firm, mutual fund, insurance company, etc.) that holds your IRA account’s investments and complies with the required IRS and government regulations. IRA custodians come in many different types with varying investment options and costs. You should research them thoroughly before establishing an account and rolling over your pension.
Step 5: Your employer provides the forms needed to request a distribution
The forms allow you to elect the type of distribution and name the IRA custodian. Some employers allow you to do all of this online or over the telephone instead of using a form. Your financial adviser can help you with this transaction to make sure everything is done properly.
Step 6: Verify the amount received by the custodian is correct
Invest the funds.
Step 7: Make sure the transaction is reported properly to the IRS
Rollovers done properly are not taxable in the year completed, but they are reportable. Don’t panic when you receive a copy of Form 1099‑R from your employer for the full amount of the rollover. Box 1 will show the total amount of the distribution. Box 2a shows the taxable amount of the distribution. This amount should be zero for a direct rollover. Box 7 should contain the distribution code “G.” This tells the IRS exactly why your retirement money was taken out and that the money was never in your hands.
Final Thoughts
Anyone between the ages of 55 and 59 ½ and separated from service with the employer offering the lump sum is not subject to the 10% early withdrawal tax penalty. However, if the funds are rolled over to an IRA, they become subject to the 10% penalty if withdrawn before 59 ½. And the distribution would still be subject to income tax. You should be confident you won’t need any of the funds before age 59 ½ before rolling them over to an IRA. The plan may allow the distribution to be split. This option would allow you to take some of the money in cash now and roll over the rest. The employer is still required to withhold 20% tax from the cash distribution to you, but you won’t be subject to the additional 10% penalty if you are over 55.
Whether to accept a pension buyout offer, and how, are important decisions and should not be taken lightly. A rollover could provide you and your heirs or beneficiaries a number of advantages over leaving money on deposit in a company pension plan. Consult your financial adviser to make sure you’ve done proper planning before making a decision. Then follow the rules so you can enjoy the benefits and sidestep the tax pitfalls.
Rick’s Tips
- Accepting a lump sum payout from a pension plan is a risk transfer from the employer to the employee.
- If you intend to roll over the entire distribution, elect the direct rollover to avoid the 20% mandatory withholding.
- Rollovers are reportable to the IRS. Don’t panic when you receive a 1099‑R for the full amount of the rollover.
