Millú Ramirez, CFP®
Moving funds from your employer’s retirement plan to your retirement account, or from one account to another? Thanks to new technology, this is simpler than it used to be. However, there are some important things you’ll need to remember to do before and after the transaction. It’s easy to make a small mistake that can end up costing you a large sum of money—either in taxes, penalties, or lost earnings. To help you be sure this doesn’t happen to you, here are 10 of the most common mistakes people make in IRA rollovers.
How It Can Happen: You have a 60-day window for moving money from your employer’s plan to an IRA rollover account tax-free. The window starts the moment your money leaves the original account. The clock starts ticking, and minor problems and roadblocks eat up time. The check gets lost in the mail. You’re on vacation when it comes in. You lose track of the days. Before you know it, the 60-day window has closed. Or one of your financial institutions could make a mistake. They might put the money into your taxable account instead of your rollover account, and you don’t notice it until after the 60-day window closes.
The Downside: In this case, the whole distribution will be taxable in one year. And if you’re under 59 1/2, you’ll pay a 10% penalty on top of that, unless an exception applies.
How to Avoid it: Request a direct transfer of the assets. Open an account with a trustworthy, reputable custodian. Then ask your plan administrator to send the assets to the new custodian. That way, you never touch the money and there’s no risk that the check will get lost or that you’ll lose count of the days. Also, if the assets go straight to the new custodian in a direct transfer, your plan administrator won’t have to withhold 20% for taxes.
How It Can Happen: Failing to pay off loans before rolling over your retirement money means that any loans outstanding when you leave the company will be considered a distribution—fully taxable and subject to penalties if you’re under 59 1/2, unless an exception applies. This can easily happen if you borrow from your 401k plan and forget—or don’t have the money—to pay off the loan.
The Downside: The loan is considered a retirement distribution, subject to taxes and penalties.
How to Avoid It: Pay off your loans before you do the rollover. Borrow the money from somewhere else if you have to.
How it Can Happen: Naming the wrong beneficiary on your beneficiary designation form is a surprisingly common mistake. Most people under ordinary circumstances tend to get this right. But some people with complex financial affairs are advised by their estate planning attorney to name beneficiaries in a very specific way. If their financial institution’s standard form won’t allow it, all that estate planning can go to waste. Another problem is neglecting to update the form after a divorce or other major life event. It has happened that an IRA went to the ex-spouse instead of the current spouse because the IRA holder never got around to changing the form after remarrying.
The Downside: The wrong people inherit your money. Or your beneficiaries end up paying too much in taxes because your estate plan wasn’t structured properly. You won’t be around to see this, of course, but it can make life difficult for your loved ones.
How to Avoid It: Sign a beneficiary designation form when you first set up the account. Then, stay aware of life events—like divorce, marriage, or death of a spouse—that will require the form to be updated. Even if you don’t experience any major life shifts, it’s a good idea to review your forms at least once a year.
How It Can Happen: Cashing out your retirement account or taking cash in the form of an “indirect rollover” can subject you to taxes, penalties, and lost growth. It’s tempting to take some or all the money out of your retirement accounts because you want to pay off debts or buy a RV or vacation home to kick off your retirement. Or maybe you just want to use the money for short time, with the intention of replacing it before the 60-day deadline.
The Downside: Anytime you get your hands on your retirement money, you face the risk of paying taxes and possible penalties on the amounts withdrawn. Any cash you take out to pay off loans or make purchases will count as a taxable distribution, reportable on your tax return. Any amount you use and fail to replace within 60 days will also count as a taxable distribution.
How to Avoid It: The safest choice is not to touch the money at all. Request a direct transfer of the assets and make sure it’s done right.
How it Can Happen: If the rollover account isn’t ready to receive funds, the administrator will be forced to send the check to you. This mistake can happen if you fail to open an IRA rollover account at your new financial institution before requesting the transfer of assets. Or there could be a clerical error—your plan administrator might not receive or heed your instructions.
The Downside: You’ll get a check in the mail with 20% withheld for taxes. If you fail to open an IRA rollover account with the institution that will be accepting the assets, your plan administrator will send the check to you where you then have 60 days to roll it into your IRA account. You will also have to come up with outside funds to replace the missing 20% from your account to avoid a tax hit.
How to Avoid It: Open your IRA rollover account with a reputable custodian and make sure your current plan administrator knows where to send the assets.
How It Can Happen: In January you’ll get a 1099-R showing the total amount of your retirement fund. It will also show you the taxable amount. This will be zero if you did a direct transfer. When you file your taxes you’ll need to show these two amounts on your tax return. Otherwise, when the IRS checks the 1099 against your tax return, it will raise a red flag. It is very easy to make this mistake. You followed the instructions for a direct transfer and then put it out of your mind because you know that the rollover won’t be taxable. So when your 1099 comes in January you ignore it or throw it away. The situation gets more complicated when you do something other than a direct or “trustee-to-trustee” transfer. Maybe you did an indirect rollover, which means 20% was withheld for taxes. In this case you’ll want to be sure you report the rollover so you can get that 20% back. Maybe you did a partial rollover. In this case you will owe some taxes, and you’ll need to make sure you report it properly.
The Downside: The consequence of not matching your tax return to your 1099 is a friendly letter from the IRS asking you to pay any taxes they think you owe based on the 1099 they got.
How to Avoid It: You can avoid this mistake by watching for your 1099 in January, checking it for accuracy, and reporting it properly.
How It Can Happen: Moving employer stock to your IRA rollover account along with the rest of your retirement assets can potentially set you up to pay more taxes down the road—especially if your stock has appreciated significantly. This is a very easy mistake to make. At the time of the rollover, you are making a choice on how proceeds from the sale of the company stock should be taxed: whether as a capital gain or as ordinary income. Capital gains are taxed at a lower rate than IRA distributions. If you take the employer stock out of your retirement plan and move it to a taxable account, then when you eventually sell the stock, your net unrealized appreciation—the amount by which the stock has appreciated compared to what you paid for it—will be taxed as a capital gain. However, if you move the employer stock to an IRA rollover account, all distributions are taxed at ordinary income tax rates, which are higher than the capital gains rate under current rules. Many people don’t realize the significance of rolling over company stock and give their plan administrator a blanket instruction to roll over everything into the rollover IRA. The administrator or financial institution can also make a mistake.
The Downside: You end up paying taxes at ordinary income tax rates (25–39.6%) instead of capital gains tax rates (15–20%).
How to Avoid It: First, check with your tax advisor if you have employer stock in your retirement plan. This is a complicated issue and specific rules apply, so get qualified tax guidance before issuing instructions to your plan administrator. There might be circumstances when you would want to move employer stock—for example, if the net unrealized appreciation doesn’t amount to much. If you decide to move the stock to a taxable account, give explicit instructions to your plan administrator for holding out the company stock from the rest of the rollover.
How It Can Happen: When you are 72, you are required to take annual minimum distributions from your IRA and pay taxes on them, even if you don’t need the money. It’s very easy to forget to take these Required Minimum Distributions (RMDs)—especially if you don’t need the money. It’s actually quite easy for the error to occur. Financial institutions often send reminders, but they cannot be responsible for forcing you to take out the required amount because you might have IRAs in different places. You might want to take your entire distribution from the IRA you have in Bank A, rather than take something from each one. Taking the required distribution on time and in the right amounts is your responsibility.
The Downside: The consequence of not taking your required distribution is a 50% penalty (you read that right) on the amount that should have been withdrawn. Say you have a $250,000 IRA and the required minimum distribution is $9,000. If you fail to take it, you’ll owe a penalty of $4,500 when you file your tax return.
How to Avoid It: You can avoid this mistake by making sure you start taking your required minimum distributions when you turn 72. Determine the value of all your IRAs, 401(k)s, or 403(b)s on the last day of the previous year and divide by your life expectancy as shown on the IRS tables. That is your RMD amount. Take that amount out of your retirement accounts by December 31. Get professional advice if you need it.
How It Can Happen: You have several options when you leave a company. You can:
- Roll your retirement funds to an IRA
- Leave the funds in your old employer’s plan
- Move old account to a plan with your new employer
Sometimes fees aren’t clearly disclosed, so you have to ask a lot of questions to find out exactly how much you will be paying in fees. Such hidden fees can be found in 401(k) or 403(b) plans.
The Downside: A common misconception is that employer plans don’t charge employees fees to invest in their plans. Remember, there is no such thing as free lunch.
How to Avoid It: You can avoid this mistake by asking about fees and understanding what you are getting for your money, or by talking to a professional.
How It Might Happen: Lots of people don’t even consider a Roth IRA for their rollover, either because they’re too focused on deferring current taxes or because no one ever told them how Roth IRAs work. If you roll your retirement assets to a Roth IRA, you will have to pay taxes on the distribution in the year you do it, but all future investment earnings will be tax-free. After you’ve gotten the initial tax hit out of the way, you will never again have to worry about paying taxes on your IRA distributions.
The Downside: The consequences come later. There are plenty of older retirees with large IRAs who are now paying huge amounts of taxes on their Required Minimum Distributions. If your income is too high, you might end up paying taxes on your Social Security benefits, or pay a surcharge on your Medicare premiums. Or your beneficiaries could end up paying more in taxes. The point is to think very long-term. No one knows what tax rates will be in the future, but it can’t hurt to try to save yourself some taxes in retirement.
How to Avoid It: You can avoid this mistake by asking a financial advisor to do a Roth analysis for you before you do your rollover. Find out if it makes sense in your case.
Have questions about IRAs and rollovers? Contact me or another planner at Urban Wealth Management and schedule a time to chat about your specific situation.
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