Brad and Cheryl, both age 55, just retired from a hi-tech international corporation headquartered on the central coast of California. Over the years, they had a “shotgun approach” to savings in their growth-oriented investments: through their 401(k)s, IRAs, and ROTH IRAs. They had taken loans on their 401(k)s to purchase their home and had juggled schedules and commitments throughout their married life. They came to us asking to “simplify” their financial life. They acknowledged they had created a “complicated” financial life. They didn’t want to make any mistakes, nor incur any costly penalties, while transitioning from “growth mode” to an “income mode”.
Brad and Cheryl were right: mistakes in rolling over retirement assets may be costly. Some funds are rollover-eligible. Some are not. Roll over the wrong funds (except for “after-tax” funds) and they might be subject to a 10% early distribution penalty, plus the entire transaction may be taxable. That could lead to a nearly 50% tax penalty! And, should the funds be rolled incorrectly to the wrong retirement account, they could be subject to an additional 6% penalty as an “excess contribution”.
With the help of Ed Slott CPA, an IRA distribution specialist, we put together a checklist of pitfalls for Brad and Cheryl to avoid in their mission to consolidate and lead a simpler financial retired life:
1. Indirect rollovers can only be done one time, per year, per person.
2. Once indirect rollover funds are taken from an IRA, ROTH, or 401(k), they must be deposited within 60 days to the new IRA, ROTH, or 401(k). In the case of IRA to IRA—or ROTH to ROTH—rollovers, the amount distributed must be the same as the amount deposited.
3. Brad and Cheryl are not yet 59-1/2 years old and would ordinarily have to pay a 10% penalty (plus the entire distributed amount being fully taxable) to the feds for any taxable retirement plan distributions. They may, however, take advantage of a retirement plan distribution exception called 72t. To qualify for the penalty exception, the withdrawals must be a series of substantially equal periodic payments for at least five years or until age 59-1/2, whichever period is longer, and the distributions cannot be rolled over. We cautioned Brad and Cheryl that they must continue the distribution of equal payments past age 59-1/2 to complete a full five years, or risk being assessed a 10% penalty retroactively for all prior distributions taken before they reached age 59-1/2.
4. Brad and Cheryl want to roll over their 401(k)s into an IRA but needed first to attend to their outstanding loans. Normally, when they roll over their plan from their ex-employer it will be offset by the amount of the unpaid plan loan. They can avoid taxes and penalties by rolling over the loan offset amount to an IRA. They have until their tax filing deadline of that year, including extensions, to come up with the cash to repay the balance. If they don’t repay the balance, it is treated as a taxable distribution, with a possible penalty.
A plan participant leaving an employer typically has four options (and may engage in a combination of these options), each choice offering advantages and disadvantages: leave the money in his/her employer’s plan, if permitted; roll over the assets to his/her new employer’s plan, if one is available and rollovers are permitted; roll over to an IRA; or cash out the account value.
Brad and Cheryl were appreciative of the cautionary advice they received, which was pertinent to their situation. There are many other pitfalls that soon-to-be-retirees need to heed. They may also look for guidance on “Required Mandatory Distributions”, “After-Tax IRA Funds”, “Hardship Distributions”, and “Divorce”.
At least now their accounts are consolidated. Their strategy is changed from growth to income, monthly retirement income is flowing, and they look forward to changing their focus to a life that is less complicated.
Should you be contemplating retirement, a call to your Financial Advisor might help in avoiding potential taxes and penalties.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax-free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59-1/2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59-1/2 may result in a 10% IRS penalty tax in addition to current income tax. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
Allen Ostrofe, MBA, CFP®, is President Emeritus of Ostrofe Financial Consultants, Inc., with clients in 32 states and is a registered Representative with, and Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Ostrofe Financial Consultants, Inc., a Registered Investment Advisor and separate entity from LPL Financial. For questions or suggestions, visit ostrofefinancial.com. Branch address: 420 Sierra College Drive, Suite 200, Grass Valley.