Follow the Rules When Rolling Over Your Pension to an IRA - Rodgers & Associates
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Follow the Rules When Rolling Over Your Pension to an IRA

Follow the Rules When Rolling Over Your Pension to an IRA

Many companies are closing out their pension plans, giving workers the oppor­tunity to roll them over to an IRA or another plan. This situation was created by the high cost of maintaining these pensions due mainly to our longer life expectancy. 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 basic rules. First, you must be separated from service to qualify for a rollover or the company must be offering to close out the plan. Second, if the funds are withdrawn from the company plan, they must be re-deposited into a quali­fying IRA or another pension plan within 60 days of withdrawal or be subject to tax. You will need to first check with your new employer to determine if they allow rollovers from other plans. Not all of them will permit rollovers. The human resource director at your new employer can help you with the infor­mation you will need to complete the paperwork for the rollover.

To rollover to an IRA you will need to first establish an IRA with a custodian if you don’t already have one. Your former employer will provide you with the forms needed to request a distri­b­ution. Then complete the forms requesting a direct distri­b­ution to your IRA custodian. Many more employers are allowing this to be done online or over the telephone. Your financial adviser can help you with this trans­action to make sure every­thing is done properly.

If you elect to touch the money in the process, you may “borrow” the funds for 60 days one time each year. This rule applies to money invested in existing IRAs as well: 60 days one time each year. The IRS has gotten a lot stricter with IRA rollovers. A new ruling aggre­gates all IRA and Roth IRA accounts, rather than viewing each account as its own entity, as was done previ­ously. Therefore, in a 365-day period, only one 60-day rollover can be completed, without tax impli­ca­tions, regardless of how many accounts one may have.

Pension plans are required to withhold 20% of the proceeds if the check is made payable to you. This means to roll 100% of your pension distri­b­ution into an IRA, you will need to come up with the tax withholding out of your own pocket. Otherwise you will owe taxes on the money you didn’t rollover and possibly a tax penalty if you are under age 55.

The easiest way to roll over a pension plan is to execute a trustee to custodian transfer. If you are married, company pension plans generally require a notarized signature of your spouse, who will be giving up his/her right to an annuity interest, for you to move the money into your IRA.

When planning for a rollover, there are several other rules to keep in mind. For example, if you are age 55 or older when the separation from service occurs, you may take your company pension as a lump sum distri­b­ution without paying the 10% early withdrawal excise tax. You will be taxed on the distri­b­ution as ordinary income. If you elect to roll the money into an IRA, this option is not available to you until you hit age 59 ½. Check with your company to see if they allow the rollover to be split, enabling you to take some of the money in cash now and rollover the rest. Keep in mind the plan will be required to withhold 20% of the amount paid to you for taxes.

If you have company stock in your plan you should consider an often-overlooked tax strategy, known as net unrealized appre­ci­ation (NUA).

How does an NUA work? Here’s an example.

An employee is about to retire and qualifies for a lump sum distri­b­ution from a qualified retirement plan. He elects to use the NUA strategy, receives the stock, and pays ordinary income tax on the average cost basis, which repre­sents the original cost of the shares. This strategy allows the tax to be deferred on any appre­ci­ation that accrues from the time the stock is distributed until it’s finally sold; and that tax is capital appre­ci­ation tax, generally less than tax on ordinary income. The NUA distri­b­ution must be taken as a lump sum distri­b­ution, not a partial lump sum distri­b­ution. To qualify for a lump sum distri­b­ution, the employee must take the distri­b­ution all within the same calendar year.

A few words of caution before you jump on the NUA bandwagon: first, an NUA distri­b­ution may not be a good idea if the company’s outlook is bleak. The tax benefits are wasted if the company stock declines signif­i­cantly after the distri­b­ution. An investor with 98% of his retirement account tied up in one stock may want to consider liqui­dating a portion of his stock position and distrib­uting a smaller portion of the stock in-kind. Finally, the NUA trans­action is compli­cated with strict rules to follow. You may want to consult a knowl­edgeable financial adviser to assist you with this trans­action.

With a little planning, a rollover can provide you and your heirs or benefi­ciaries several advan­tages over leaving money on deposit in a company pension plan. By following the rules, you can enjoy the benefits and sidestep the tax pitfalls.

Rick’s Insights

  • Company retirement plans are required to withhold 20% of distri­b­u­tions made directly to a person for income taxes.
  • Distri­b­u­tions from a company plan are not subject to the 10% early withdrawal penalty if you are age 55 and separated from service.
  • Net unrealized appre­ci­ation (NUA) is a compli­cated strategy that may offer signif­icant tax savings if you hold company stock in your employer’s plan.