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Once you leave your company, you must decide what to do with your retirement plan assets. Knowing your distribution options, and how they will affect your retirement savings, can make the difference between having a comfortable retirement and not having one at all.
Direct Rollover into an IRA: The easiest way to avoid any mandatory state or federal withholding taxes, as well as a possible 10% penalty, is to directly rollover your entire plan into an Individual Retirement Account (IRA). An IRA is a tax-deferred account that can be used to receive retirement benefits distributed from an employer-qualified plan. Since all earnings continue to accumulate on a tax-deferred basis, your money will compound and accumulate more rapidly than money placed in an otherwise identical taxable account. Investments in an IRA can include stocks, bonds, government securities, unit investment trusts and mutual funds. Since most IRAs give you more investment choices than employer sponsored plans, they give you the power and flexibility to shift your investments as your goals and economic conditions change.
If for some reason you have already received your lump-sum distribution, minus the 20% mandatory withholding, all may not be lost. You have 60 days from the date you received your payout to invest these funds into an IRA, along with an additional 20% of your own money to cover the amount withheld. When you file your income tax return, you will receive credit for the 20% withheld. But remember, you only have 60 days to do this. If you fail to act within the 60 days, your entire payout will be subject to state and federal income taxes, a potential 10% premature distribution penalty, and its tax-deferred status will be lost forever.
Taxable Distribution: Although taking a taxable distribution can give you access to the savings in your retirement plan, there are several things to consider when taking a lump-sum distribution:
State and federal income taxes will take a "bite" out of your distribution: When you were making contributions to your 401(k), you most likely did so with pre-tax dollars. In addition, employer contributions to a qualified plan on your behalf were also tax deferred. Upon distribution, you have to pay current income taxes on all pre-tax contributions and earnings.
There is a 20% mandatory federal income withholding tax that is applied to eligible rollover distributions: If you elect to receive a check directly from your employer, you will only receive 80% of your distribution. In essence, if you expect to receive a check for $100,000, your employer will withhold 20%, or $20,000, and send you a check for $80,000.
A 10% penalty may also apply (also known as a premature distribution penalty). Generally, if you are under age 59 1/2 you will have to pay the IRS an additional 10% penalty when you file your federal income taxes next year. There are certain exceptions to this rule, such as death, disability, or substantially equal payments.
Transfer Funds to Your New Employer's Plan: If your new employer's plan accepts rollovers from another employer's plan, you can transfer the funds directly to its 401(k) plan or other type of qualified employer plan, avoiding current income taxes and the 20% withholding tax.
Keep Funds in Your Old Employer's Plan: For account values of $5,000 or more, you may be able to keep your funds in your former employer's plan. Your funds will continue to accumulate tax-deferred, and can later be moved to a new employer's qualified plan or an IRA without penalty. If you are over the plan's retirement age or age 62, your company may insist that you take a payout in order to decrease the plan's administrative costs. If this happens, you still have the option to make a direct rollover to an IRA.
Do you have company stock in your retirement plan?: If your plan allows you to take in-kind distributions of company stock, be careful! There are special tax rules that apply to company stock in retirement plans, and making the wrong decision could cost you-significantly. Although rolling over your company stock to an IRA may allow you to avoid paying taxes and penalties right now, you may benefit more by using a provision known as NUA (Net Unrealized Appreciation). By having the stock shares sent to you in a taxable form, you only have to pay taxes on the cost basis of the stock. However, once you sell the stock, any earnings will be treated as capital gains rather than ordinary income.
401k Rollover Plan Update