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Taking money from an employer-sponsored retirement plan could potentially have adverse consequences if done incorrectly. Recently, two cases have come across my desk that really drives this fact home. We all want to do what’s necessary to get the most out of our dollars. In the investment world, this frequently means focusing on fees, expenses, and asset allocation. But let’s take a bit of a detour and shine a light on something that gets little attention: a common procedural error.
By and large, most employer-sponsored retirement plans contain pre-tax dollars. As you might expect, these are dollars that never have been taxed. (Put aside your Roth contributions for now). When you leave your employer, you’ll have an option to move these pre-tax dollars to another retirement account.
Moving to another qualified retirement account is known as a rollover, and when done directly from institution to institution, it’s a non-taxable and penalty-free transaction. An indirect rollover, however, is a bit different. With an indirect rollover, the former participant in the company retirement plan has a check issued directly to them, which they would presumably cash and then transfer into another retirement account. So long as the money goes back into another retirement account within 60 days, these dollars also would be tax-free and penalty-free. Understanding the subtle difference between indirect and direct rollovers should be a priority when it comes to your retirement planning. Problems can arise when it comes to withholding. Withholding is the money that an employer deducts from your paycheck (for taxes) and sends directly to the government.
When your employer issues a check to you from your retirement plan, they are required to withhold no less than 20%. This rule comes straight from the IRS. Even though you may redeposit the remaining 80% of what you have into a qualified account, when tax time comes around, the IRS will treat this transaction as though you withdrew 20% from your IRA and left it in your bank account. This 20% is fully taxable and potentially subject to penalties if you are under age 59.5! Consider an example:
Joe is 41, married with two kids, and just left his job as a marketing manager to run a team of salespeople at a tech start-up company for a handsome $170,000 per year. He is a good saver and built up $100,000 in his 401(k) with the previous employer. Joe is busy getting acclimated to his new role and managing a work-life balance. He wants to wrap up loose ends at his old job as soon as possible. He requests a distribution from his old 401(k) for $100,000 and receives a check, after withholding, for $80,000. He deposits this into his savings account for a few days while he gets his new 401(k) set up, then immediately deposits it into his new employer’s plan.
Joe distributes $100,000 but only puts $80,000 back into a qualified account. The IRS will include the $20,000 of withholding in his income for the year. This takes him from $170k of income to $190k of income. Fortunately, he stays in a 28% marginal tax bracket even with the extra income, which will add only a cool $5,600 (or 28% of $20,000) to his taxes for the year. In addition to ordinary income taxes, he will also have to pay a 10% penalty on the full $20,000 withheld, or an additional $2,000. Joe isn’t 59.5 years of age yet and the withholding amount is considered to be an early distribution. More salt in his wound.
The net impact of this is an extra $7,600 in taxes and penalties. Joe can avoid the consequences in one of two ways:
How can he do this when some retirement plans insist on mailing a check to the address of record for any retirement plan distribution? Possession of a check does not automatically make it an indirect rollover. When requesting the distribution, have the check made payable to the custodian of your new retirement plan followed by the letters “FBO” and your name. (FBO stands for “For the Benefit Of”). Include your new retirement plan account number in the memo line of the check if you have it.
The check may be mailed to you but it won’t be payable directly to you. It’s payable to your new retirement account and therefore qualifies as a direct rollover. You may have possession of the check, but in this scenario, it’s helpful to think of yourself as a courier between the two financial institutions. Couriers don’t pay the tax: they simply facilitate the transaction.
It’s best to work with a qualified professional when it’s time to roll over your retirement dollars. Mistakes can potentially be costly. Proceed cautiously, enlist help, and be diligent with your retirement savings.
This article was contributed by Matt Bacon, CFP® Associate Financial Advisor with CUSO Financial Services, L.P.§ at UFCU. Matt is a native Austinite, Longhorn fan, Sunday league amateur soccer player, and overconfident Yelp reviewer.
§ Non-deposit investment products and services are offered through CUSO Financial Services, L.P. ("CFS"), a registered broker-dealer (Member FINRA/SIPC) and SEC Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the credit union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. UFCU has contracted with CFS to make non-deposit investment products and services available to credit union members.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.