Is a Rollover IRA Rght For You?
In this time of job changing and downsizing, you will probably need to know what to do with your company-sponsored retirement plan at least once before you enter the golden years. Once you leave a job, you will need to make a decision as to what to do with your retirement plan. You can move it into your new employer’s plan (if they have one) or you can take the lump sum and pay the tax, and potential tax penalties. Some companies also allow you to leave the retirement plan intact until you reach retirement age. A final option is to rollover the plan into an individual retirement account or as it is most commonly known, a Rollover IRA.
What is a Direct Rollover IRA?
A direct rollover means to move money directly from an employer-qualified retirement plan, such as a 401(k), into an IRA. If you receive a payout from your company-sponsored retirement plan, a Rollover IRA could be to your advantage. You will continue to receive the tax-deferred status of your retirement savings and will avoid the pesky penalties and taxes that come along with cashing out. However, the procedure can be a tricky one – it is important to call your human resources department and receive their “rollover kit,” as the forms and procedures are often unique from company to company. For example, your company may send retirement balances out at certain times of the year (e.g., quarterly, monthly, etc.) or will only send the check to your home address. The latter may cause a roadblock, as it is key to have the check made out to your new IRA sponsor’s name (e.g., Fidelity Investments, etc.) with the term FBO (for the benefit of) you, the employee. The IRS does not consider this “constructive receipt” and no taxes, or penalties are incurred, but you must deposit the check into your new IRA account within 60 days.
Advantages of a Rollover IRA
The benefits of a Rollover IRA are what attract most investors to the product. Below are five primary reasons people choose Rollover IRA’s:
1. Avoid Paying Income Taxes – A direct rollover relieves you of the mandatory 20% income withholding by the IRS if you cash out.
2. Continue Tax-Deferred Status – Any money that you contribute to the Rollover IRA will continue to be untaxed until you withdraw the assets.
3. Avoid Federal and State Tax Penalties – If you cash out before retirement age, not only will you pay the 20% income taxes mentioned above, but there will be a 10% federal tax penalty, and in some states, such as California, another 10% state tax penalty will be applied. Combined, California residents will pay a staggering 40% income tax and tax penalties if they chose to cash out early.
4. Maintain Complete Control of Your Assets - If you want complete control of your Rollover IRA, you can combine it with any existing IRAs you may have for the simplicity of having only one IRA account, which allows for easier tracking and management of your assets. Unlike company-sponsored retirement plans, you, as the IRA account owner, make the key decisions that affect management and administrative costs, investment strategy and asset allocation.
5. Greater Flexibility – A Rollover IRA provides greater flexibility during estate planning to help your beneficiaries maintain tax-deferred growth for multiple generations.
Making Contributions to a Rollover IRA
The Rollover IRA is usually funded by the eligible distributions from a qualified company-sponsored retirement plan. These distributions can be combined with an existing IRA or into a separate IRA. If you create a separate IRA for your rollover, you can easily move these funds to another employer-sponsored plan in the future if the company allows this. It's is sometimes a good idea to keep your Rollover IRA separate from any other IRA's you might have, because once you make contributions to a rollover that are not from a company-sponsored plan, you lose the right to move this rollover to another company-sponsored plan.
Distributions from a Rollover IRA
The distribution rules for a Rollover IRA are the same as the rules for a traditional IRA. Contributions and earnings are taxed when withdrawn after age 59 ½. Withdrawals before the age 59 ½ are taxable and may be subject to a 10% penalty. However, if you are under 59 ½ and decide to retire, you can still take advantage of an existing tax code 72(t), which requires that you still pay the federal and state income taxes on distributions, but allows you to take penalty-free distributions from your IRA. Withdrawals must begin by the year after you reach 70 ½ to avoid penalties.
Rollover IRAs are not for everyone; however, for most, consolidating their retirement plan assets or "rolling them over" into an IRA offers some unique advantages often not available in a company-sponsored retirement plan. Before making any decisions about your retirement plan and distributions, be sure to discuss your retirement strategy with your certified financial planner and/or accountant.
Brian R. Carruthers: CFP, CMT, has successfully advised and managed the investments of OC residents for over 20 years. He is the founder and president of Brian R. Carruthers & Associates, a Laguna Beach-based SEC registered investment advisory firm.
