After exiting a job, you're generally well advised to roll over money from your former employer's qualified retirement plan (or plans) into your own individual retirement account. In some instances keeping your money in the former employer's plan may give you access to lower-cost investment options, but generally the rollover route gives you more control and choice over investments while continuing to defer taxes. Here are three things to consider.
Arrange for a "direct" rollover. If you decide to do a rollover, just be sure to arrange for a "direct" (trustee to trustee) rollover from the plan into your IRA. The check or electronic transfer from the plan should go directly to the trustee or custodian of your IRA. While you must have an IRA set up and waiting to receive the rollover, the account can be empty before the transfer.
Here's why doing a direct rollover is so important. If you receive a retirement plan check that is made payable to you personally, 20% of the taxable amount of the payout must be withheld for federal income tax. This little-known rule applies regardless of your age. Then you'll have only 60 days to come up with the "missing" 20% and get it into your IRA. Otherwise you can't accomplish a totally tax-free rollover. You'll owe income tax on the 20% and maybe the dreaded 10% premature penalty tax too if you're under age 55.
Example: After leaving your job at age 52, you're due $100,000 from the company 401(k) plan. You want to roll over the entire $100,000, but you fail to arrange for a direct rollover. So you receive a distribution check made out to you personally. Surprise: The check is only for $80,000. The "missing" $20,000 went to the IRS for mandatory federal income tax withholding. Now you'll have to scrape up $20,000 and get it into your IRA within 60 days to pull off a totally tax-free rollover. Say you manage to do that. That's great, but you can only recover the $20,000 sent to the IRS via reduced tax payments over the remainder of 2011 or by claiming a refund when you file your 2011 return next year. Either way, it takes a long time to get your money back.
What if you fail to come up with the $20,000? You'll owe federal income tax on the $20,000 (because it wasn't rolled over) plus you'll owe another $2,000 for the 10% premature withdrawal penalty (because you're under age 55). You'll eventually get some money back from the IRS (the difference between the $20,000 that was withheld and what you actually owe on that amount). But getting the money back will take a long time.
Don't roll over money you need. If you're 55 or older when you receive a payout from your former employer's qualified retirement plan, you won't owe the 10% premature withdrawal penalty tax on money you choose to keep in your own hands; you'll still owe income tax. In contrast, if you roll the money into your IRA and then need to withdraw it later on before reaching age 59 , you'll generally owe the 10% penalty tax on top of the income tax hit. Plan ahead to avoid getting slammed with the 10% penalty.
Put inherited money into your own IRA. If you inherit your spouse's qualified retirement plan account or IRA, you should roll the money over into an IRA set up in your name. I recommend doing it relatively quickly -- no later than the end of the year after the year your spouse dies. Otherwise, some complicated rules can kick in and spoil your chance to continue deferring taxes. By quickly arranging for a rollover into your own IRA, you'll get total control over the money, and you won't have to take any annual required minimum withdrawals (and pay the resulting income taxes) until you reach age 70 . Instead, you can continue earning tax-deferred income. With retirement account money, tax deferral is the name of the game.
If you inherit your spouse's Roth IRA, roll the money into your own Roth account. That way, you won't have to take any required minimum withdrawals for as long as you live. You can continue earning federal-income-tax-free income until you depart this cruel orb.