In most cases, the strategy of rolling over a company retirement plan payout into an IRA is a good idea. That way, you can continue to defer taxes on the rolled-over balance -- as well as future income earned on that balance -- for as long as you leave the money in the IRA.
Unfortunately, with taxes there's really no such thing as a sure thing. The rules are so complicated that even the experts have to work hard to keep up. That's why I always tell you to consult a good tax pro before making any significant financial moves -- even when you think you have a perfect understanding of the tax consequences. To prove the point, here's a real-life IRA rollover story with a very bad tax outcome that could have been easily prevented with a little advance planning.
The 10% Early Withdrawal Penalty and the Age-55 Exception
The general rule says the taxable portion of a pre-age 59 withdrawal (a so-called early withdrawal) taken from a qualified retirement plan (such as your company's 401(k) plan) will be hit with a 10% early withdrawal penalty unless some tax-law exception gets you off the hook. The same general rule applies to early withdrawals from a traditional IRA.
For early withdrawals from a qualified plan, there's an exception for withdrawals taken after you've reached age 55 if you have also separated from service. I call this the age-55 exception. Separation from service means permanently leaving the company for any reason. In this scenario, the age-55 exception allows you can take a payout from the company plan, keep some or all of the money instead of rolling it into your IRA, and not owe the 10% early withdrawal penalty on the money you keep. To be clear, you will owe income taxes on the money you keep, but you won't get socked with the 10% penalty. You can roll over the rest of your company plan money into an IRA without owing anything to the Feds.
There's No Requirement for Tax Rules to Make Sense
The important thing to understand here is that there is no age-55 exception for early withdrawals from an IRA. That's because the list of qualified retirement plan exceptions to the 10% early withdrawal penalty is not exactly the same as the list of IRA exceptions to the 10% early withdrawal penalty. That makes no sense, but our beloved Internal Revenue Code is riddled with rules that make no sense.
Anyway, in a recent court decision, one taxpayer found all this out the hard way. At age 56, the taxpayer, Mr. Young Kim, left his law firm job to enroll in the London School of Economics. He rolled over the balance from his firm's qualified retirement plan account into an IRA. The next year, when he was 57, he withdrew about $240,000 from the IRA and paid the resulting federal income tax bill. But he did not pay the 10% early withdrawal penalty because he believed he qualified for the aforementioned age-55 exception. He was wrong because, as I said earlier, the age-55 exception does not apply to early IRA withdrawals.
After auditing Kim's return, the IRS assessed the 10% early withdrawal penalty plus an additional penalty for substantially understating his tax bill by failing to include the 10% penalty on his Form 1040. Kim argued that it was illogical for the age-55 exception to be available for early qualified plan withdrawals but not for early IRA withdrawals. So he took his case to the Tax Court, which observed that there is no requirement for the tax law to be logical. It says what it says, logical or not. Therefore, the Tax Court concluded that Kim owed over $24,000 in penalties. Ouch!
The still-unconvinced Mr. Kim then took his case to the Seventh Circuit Court of Appeals. Unfortunately for him, the Appeals Court saw things the same way as the Tax Court. Strike two, you're out!
What the Taxpayer Should Have Done
Since Mr. Kim left his law firm job when he was over age 55, he qualified for the age-55 exception to the 10% early withdrawal penalty. Therefore, he should have simply withdrawn the $240,000 that he was going to need from the firm's retirement plan. He could have done that without owing the 10% penalty, thanks to the age-55 exception. He could have rolled over the balance of his retirement plan money into his IRA with no taxes due. Instead, he rolled all his retirement plan money into the IRA and took the needed $240,000 from that account. Because the IRA withdrawal occurred while Kim was under age 59 , he got socked with the 10% early withdrawal penalty. This sad story illustrates that rolling all your company retirement plan money into an IRA is not always the tax-smart move. Almost nothing is for sure when it comes to taxes! Source: Young Kim, 7th Circuit Court of Appeals, 2012.
The Bottom Line
What happened to Mr. Kim is a classic example of the kind of bad tax results that can occur when well-intentioned folks act on their own versus the much-better tax results that can often be achieved with the benefit of competent professional advice. Once again, please consult a good tax pro before making major financial moves. The extra expense is usually worth it.