Protecting Retirement Assets: An IRA Rollover Review Continued

In our last article in this blog series about IRA rollovers, we introduced earning power and what it means for one’s financial future. We also discussed some of the options available to employees who have employer-sponsored retirement plans but are transitioning to new jobs with new employers.

When you have a retirement plan with a former employer, what should you do with the funds you’ve accumulated in that plan when you move to a new job? Should you take the money out, leave it, or explore the option of a rollover. In this article, we’ll go even further in detail on the three primary options available, focusing on the best option of them all: the rollover. Let’s get started.

The Bad Option: Lump-Sum Distribution

In our last article, we talked about taking retirement funds out of the former employer’s retirement plan. This is called a lump-sum distribution, and although on its surface it sounds like a good idea, the reality is that it is potentially the worst of all options available. Why is that? The simple answer is tax penalties.

If you choose to withdraw those retirement funds in a lump-sum payment, it is considered taxable income, with the tax implications that follow, including being pushed to a higher tax bracket and having to pay even more in income taxes both on the state (if applicable) and federal levels. Add onto that a mandatory 20% withholding at the time of distribution and suddenly you are potentially facing thousands of dollars in tax payments, depending on the amount of funds distributed. There may also be an early withdrawal tax penalty, called a premature distribution tax, typically at 10%. To illustrate this further, let’s look at an example:

Imagine you are under the retirement age of 59 1/2, and you are in the 28% federal income tax bracket. You’ve managed to save $100,000 in your employer-sponsored retirement plan, and you’re moving to a new employer. You choose to withdraw your retirement assets in a lump-sum distribution.

Now, take 20% off the top for the mandatory federal income tax withholding. That shaves off $20,000, leaving you with $80,000. Next, pay 8% in additional income tax based on the fact that the lump sum is considered taxable income. That’s another $8000 in taxes. Now, pay the 10% premature distribution tax, which removes another $10,000 from the total. You’re left with $62,000, and you no longer have the benefit of tax-deferred growth in a qualified retirement plan.

It is clear to see with these hypothetical figures that the lump-sum distribution option results in thousands of dollars in unwanted taxes and penalties, not to mention the losses of growth in a tax-deferred plan.

The Better Option: Leaving the Funds in Place

Don’t wish to lose money on taxes and penalties? Many employees choose to keep the retirement funds in place with their old employer, despite having a new job with another company. This is a better option than the lump-sum withdrawal, provided that the growth in this retirement plan is in line with your financial goals and needs. The money continues to grow on a tax-deferred basis until you reach retirement age or choose to take a lump-sum distribution. If the plan is performing adequately, you can sit back and relax, knowing your retirement assets are safe.

Remember, though, that if you are an employee with less than $5000 of value in a qualified employer-sponsored retirement plan, you may be required to withdraw the money if you should find new employment. And, because this happens in a lump-sum, this is taxable income with the tax implications you should be working hard to avoid. So, leaving the funds in place is a better option than taking an early distribution, but this option is not available to all employees.

The Best Option: The Rollover

When you transition to a new job with a new employer, or an employer-sponsored retirement plan is terminated, a special option becomes available: the IRA rollover. There are actually two ways in which this rollover can be used as part of a qualified plan distribution. Let’s explore these two ways in more detail:

The Retirement Plan Conduit – in this strategy, the qualified plan distribution is transferred directly into a traditional IRA rollover. Here, it maintains its tax-deferred status until the time in which it is transferred again, this time to a qualified retirement plan sponsored by the new employer. Not all plans allow this method; consult with a retirement professional and company HR personnel for details.

The Retirement Asset Accumulation Model – in this rollover plan, the qualified plan distribution is transferred to a traditional IRA rollover, just like with the plan conduit strategy. This time, though, the funds are left in the IRA to continue to accumulate value through tax-deferred growth. This continues until you reach retirement age and are ready to take distributions without tax penalties. During this time, an employee is free to take advantage of any employer-sponsored retirement plans that the new employer may have available, helping lay the foundation for a stable financial future.

Two IRA Rollover Methods

Now that we’ve introduced rollovers and looked at the two ways in which employees can use this option to protect retirement assets, it is time to explore the concept of rollovers in more detail:

Indirect Rollovers – in this rollover method, the distribution is paid to the employee/account holder. The account holder has 60 days in which to roll over the fund distribution to the new employer-sponsored retirement plan or to a traditional IRA of the account holder’s choosing. Because the distribution is first paid to the employee, the plan’s administrator is required to withhold 20% of the total value of the distribution. However, even though you are receiving only 80% of the distribution, the full 100% must be rolled over into the new qualifying plan. That means that employees must often scramble to make up the difference using other funds. The good news is that when you file your federal taxes for the year, you can request a refund of the 20% that was withheld in the indirect rollover distribution.

Direct Rollovers – don’t like the sound of a 20% withholding on your distribution? Financial experts do not either, and recommend the direct rollover as a means of protecting retirement assets. The direct rollover “skips the middleman”, in a sense, transferring the funds directly from the old employer’s plan directly to the new employer’s qualifying retirement plan or to the traditional IRA owned by the employee. This is sometimes referred to as a trustee-to-trustee transfer. By using the direct rollover method, you avoid the 20% withholding tax and the full amount of your retirement funds can continue to grow unabated.

In both of these methods, it is useful to know that the funds contained in employer-sponsored retirement plans are protected from creditors if the employee should file for bankruptcy. The same may not apply to funds held in an IRA; while there are some protections, it is a good idea to rollover assets into a separate IRA account rather than adding them to an existing IRA you may already have established.

In our next and final article on IRA rollovers, we will discuss some of the additional details you will need to make smart decisions about your financial future. Stay tuned for more critical information on this retirement assets preservation option.


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