The IRA Tax Trap
An IRA rollover can be an excellent tax strategy; however, certain federal income tax rules can prove hazardous if not planned correctly.
For instance, if you do two IRA rollovers within one year, each withdrawal counts as a taxable distribution and could trigger income taxes and even an early withdrawal penalty tax of 10%. To avoid this pitfall, only conduct one rollover every year between accounts.
1. Rolling Over Company Retirement Plan Balances
If you take a distribution from an employer’s plan and don’t immediately deposit it in an IRA, that amount is considered income and may incur the 10% early withdrawal penalty tax. To prevent this problem, arrange for direct rollover within 60 days for maximum efficiency.
Direct rollover involves an immediate transfer from the company plan to your IRA custodian, maintaining the tax-deferred benefits while giving you full control over investment options and fees. This method offers greater tax efficiency than indirect rollover, in which a check is sent directly to you with instructions to transfer funds into an IRA account; should this approach be chosen, however, 20% must be withheld from taxes by the company.
2. Rolling Over Individual Retirement Account Balances
Though you might be tempted to keep your retirement funds within the company plan, it’s often beneficial to roll them over into an individual retirement account (IRA). That way, you’ll expand your investment options by including mutual funds and exchange traded funds; or choose a self-directed IRA that enables you to invest in unorthodox assets such as real estate.
When receiving distributions from employer plans and not directly transferring them into an IRA within 60 days, 20% of any taxable amounts must be withheld for federal income tax withholding purposes. Each year you only qualify for one rollover between IRAs.
Naming your IRA beneficiaries correctly is of equal importance, since otherwise their beneficiaries could face unexpected and undesirable tax implications.
3. Direct Transfers
Direct transfers occur when a retirement account owner moves funds directly from one IRA to another without using indirect rollovers, eliminating the potential for creating a taxable event.
Typically, when receiving a check from your retirement plan that’s payable directly to you or another financial institution and not deposited in an IRA within 60 days, the IRS treats this distribution as a taxable event and you may need to pay income tax on what was withheld plus possibly incur a 10% early withdrawal penalty tax if under age 59.5.
Avoid this trap by asking for a trustee-to-trustee direct transfer between IRA custodians. Checks written out to “for the benefit of” (FBO) the account owner qualify as such direct transfers.
4. Roth Conversions
Roth conversion refers to the process of moving assets held within Traditional, SEP, SIMPLE IRAs or qualified employer sponsored retirement plans (QRP) such as 401(k), 403(b), 457(b) plans into Roth accounts before taxes have been applied – with potential taxable income as well as potential tax-free growth being included in this transaction.
As it can be hard to accurately forecast your tax bracket in the future, Roth conversion can be risky; you could end up paying higher taxes later.
However, Roth conversion may make sense if your tax rate will decrease upon retirement or your heirs inherit large sums that will move them into higher tax brackets. Just make sure there is enough cash in a taxable account to pay upfront income taxes when converting.
5. Required Minimum Distributions
The IRS mandates that you withdraw at least a minimum amount known as Required Minimum Distributions (RMDs) annually from certain types of retirement accounts such as traditional IRAs, SEP IRAs and SIMPLE IRAs as well as profit sharing plans such as 401(k), 403(b) profit sharing plans and 457(b) tax-deferred annuities.
RMDs are one of the most common retirement account traps that we see our clients fall into, not only triggering income tax liabilities but also expensive penalties.
Avoiding financial pitfalls requires careful planning and execution, which we can assist with. Reach out if you need any assistance; we are here to guide your path to financial freedom!
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