Retirement FAQs - Answers to Your Rollover Questions - Rodgers & Associates

Retirement FAQs — Answers to Your Rollover Questions

Money Trap

This week’s newsletter is a contin­u­ation of a series I started last year on the most frequently asked question about retirement.

See the other posts in the series here:

Tax traps are a common problem when dealing with retirement plans. Taking withdrawals too early or too late can trigger penalties. This installment explores some of the tax issues you will need to navigate in retirement.

I’ve heard that if I take my “rollover” money out of my company account, my employer will withhold 20%? Is this true? It is true. If your company writes you a check for your pension balance, even if you intend to deposit it into an IRA, they must withhold 20%. Therefore, if you deposit the check into an IRA, you must use funds from other sources (for instance, other savings or borrowing) to make up the withheld amount. Otherwise, you must pay income taxes on the 20% that is withheld and not rolled over into the IRA. The amount withheld for taxes may also be subject to an early withdrawal penalty if you have not reached the age of 55.

Is there a way I can avoid having 20% withheld from my rollover? Yes. You can arrange to have the funds trans­ferred directly from the pension into an IRA. In that case, your company writes the check to the custodian of your IRA, not to you, and there is no withholding applied to the account balance. This is called a direct rollover to an IRA. The direct rollover won’t be subject to 20% mandatory withholding. The rollover will still be reported to the IRS as a distri­b­ution, but it’ll be coded as a rollover on the 1099‑R, a tax reporting document similar to the 1099-DIV brokerage firms use to report dividend income. You’ll need to show the amount on your tax return for the year the money was distributed, but it’ll appear as a rollover and therefore won’t be taxed.

Is there a way to take money from my retirement accounts before age 59 ½ without penalty? Taking distri­b­u­tions from a qualified plan before you turn 59½ makes those distri­b­u­tions premature. Distri­b­u­tions made prior to age 59½ that aren’t rolled over to another plan are generally subject to a 10% penalty. However, there are excep­tions, including:

  • Death
  • Permanent disability as defined by the Internal Revenue Code
  • Attainment of age 55 and separation from service
  • Unreim­bursed medical expenses in excess of 7.5% of your adjusted gross income
  • Distri­b­u­tions made to a former spouse pursuant to a qualified domestic relations order
  • 72(t) payments
  • Financial hardship (if permitted by the plan)
  • Plan termi­nation without a successor plan named
  • Required minimum distri­b­u­tions from inherited accounts

What are 72(t) payments? Section 72(t) of the Internal Revenue Code, which imposes the 10% early withdrawal penalty on IRAs, also allows specific types of penalty-free distributions—known as a series of substan­tially equal payments or 72(t) payments—prior to age 59½. Generally, 72(t) payments are the surest way to make yourself eligible for penalty-free retirement account withdrawals before age 59½. To implement these payments in your early retirement strategy, simply follow these three basic rules:

  1. You must take a series of withdrawals (at least annually) with the amounts based on one of three methods we discussed in the last section: minimum distri­b­ution, fixed amorti­zation, or fixed annuitization.
  2. With a company plan or 401(k), you must be separated from service. That means you must have quit, retired, been laid off or fired, or otherwise left your job. With a tradi­tional or Roth, SEP, or SIMPLE IRA, you can use the 72(t) strategy at any time.
  3. Once you start taking 72(t) withdrawals, you must stick with the program for at least five years or until you reach age 59½, whichever comes later. You can’t modify the account or payments in any way. To do so will subject all payments taken under the plan to the 10% premature withdrawal penalty.

You mentioned age 55. Don’t you need to be age 59 ½ to avoid penalty? The standard 10% premature-withdrawal penalty applies to IRAs for those under age 59½. But the penalty is waived for withdrawals once you reach age 55 and are separated from service from company sponsored plans such as 401(k)s, 403(b)s and 457 plans. This is an important planning consid­er­ation for an early retiree. You need to check with your employer to determine what they’ll allow you to do with these funds after you retire. Many employers won’t permit periodic distri­b­u­tions, since in that case, the employer will continue to be respon­sible for reporting distri­b­u­tions and balances to the IRS.

See the other posts in the series here:

Rick’s Tips:

  • Distri­b­u­tions from employer sponsored plans have a 20% mandatory tax withholding requirement for payments made to the employee.
  • A direct transfer to an IRA or another employer sponsored plan avoids the tax withholding.
  • A series of substan­tially equal payments or 72(t) payments will avoid the 10% penalty for distri­b­u­tions from a retirement plan made before age 59 ½.