The Best and Worst IRA Rollover Decisions
IRA owners and their advisors make expensive mistakes handling these accounts. These mistakes range from simple to complex.
A simple mistake occurs when an employee takes a check when he retires, and has 20 percent withheld when they could have had 100 percent of the funds by using a trustee transfer. They cannot complete the 60-day rollover without tax because he only has 80 percent of the amount the IRS requires gets rolled over. Then there's the more complex — the advisor who does not realize that his client was born prior to Jan. 1 1936 and qualifies for 10-year averaging. The tax on the funds would potentially be 20 percent using averaging, but may be as much as 35 percent if a normal rollover is completed.
Read on for the dos and don't's of handling IRAs.
Best
1. Leave money in the qualified plan if retiring between ages 55 and 59½ and distributions are required.
Since there is no penalty on withdrawals from a qualified plan after attainment of age 55 and separation from service, distributions are more liberal than if funds are rolled to an IRA. Therefore, it's best for people who need money from their retirement account in this age bracket to leave the money as is.
2. Make optimal use of creditor protection.
Some advisors think that the recent changes to the federal bankruptcy rules automatically protect IRAs. This is not true. For creditor protection purposes, an individual is best to leave his funds in his qualified plan because ERISA gives complete creditor protection to qualified plans (note that one-person qualified plans don't get the protection — there needs to be at least one real employee in the plan). If the individual does roll over his qualified plan into an IRA, it is optimal to leave these funds in a separate rollover IRA because the protection that the funds had under ERISA will follow the funds into the rollover IRA.
Note that rollovers that do not come from an ERISA plan are protected only up to $1 million. Consequently, a rollover from a SEP or SIMPLE IRA to a traditional IRA would appear to forfeit unlimited protection and potentially subject the assets to the $1 million aggregate traditional and Roth IRA protection cap.
Worst
1. Roll over company stock.
Shares of employer stock get special tax treatment, and in many cases, it may be fine to ignore this special status and roll the shares to an IRA. This would be true when the amount of employer stock is small, or the basis of the shares is high relative to the current market value.
However, in the case of large amounts of shares or low basis, it would be a very costly mistake not to use the Net Unrealized Appreciation (NUA) rules.
If your client's company retirement plan includes highly appreciated company stock, have him withdraw the stock and roll the balance of the plan assets to an IRA. This way they'll pay no current tax on the Net Unrealized Appreciation (NUA), or on the amount rolled over to the IRA. The only tax would be on the cost of the stock when acquired by the plan.
2. Roll over after-tax dollars.
Sometimes qualified plan accounts contain after-tax dollars. At the time of rollover, it is preferable to remove these after-tax dollars, and not roll them to an IRA. That way, if the account owner chooses to use the after-tax dollars, he will have total liquidity to do so.
Clients can take out all of their after-tax contributions — tax-free, before rolling their qualified plan dollars to an IRA. They also have the option to roll over pre-tax and after-tax funds from a qualified plan to an IRA and allow all the money to continue to grow tax deferred.
Before you recommend a roll over, find out if your clients will need the money soon. If they do, it probably wonÕt pay to rollover the after-tax money to an IRA because they cannot withdraw it tax free. The after-tax funds become part of the IRA, and any withdrawals from the IRA are subject to the Pro Rata Rule.