Getting the Loot to an Individual Retirement Account
Managing Your Retirement
If you've read our articles on receiving money from defined benefit plans, defined contribution plans, or profit sharing plans, then you're probably giving a bit of thought as to how to move that money into an Individual Retirement Account (IRA). This article will hopefully help you avoid the mistakes that can occur if you do not exercise a little care when making this transfer.
First, your company's plan may have restrictions as to when money may be distributed. As an example, many defined contribution plans restrict withdrawals to certain times of the year or month. To learn about any applicable plan restrictions, go bother the Human Resources folks in your office. They should be able to tell you what to expect, and if they can't, try to figure out from them just what else it is that they get paid to do.
Second, to get this money to an IRA with no possibility of a tax problem, you should arrange for a direct transfer of all distributions to that vehicle. This is known as a custodian-to-custodian transfer. Both your defined contribution plan custodians and future IRA custodians will know how to do this and can guide you through the process. You definitely do not want to receive a check made out in your name for the plan's proceeds.
This then qualifies as one of the very, very few times in life when the proper response to receiving a couple-hundred-thousand-dollar check in your name is not "Woo-hoo!" It's understandable that a lot of people make mistakes with this step. But you need to know that plans must, by law, withhold 20% for possible income taxes on any amount distributed whenever they cut a check payable to you, even if you cross your heart and promise to deposit the money right away in your IRA.
If you get a check from your plan payable to you, then in order to complete a 100% rollover of the retirement money, you must come up with the missing 20% from other resources, probably by removing money from your bank account. You would then add that 20% to the 80% you got from the plan, and deposit those proceeds into the IRA within 60 days. If you fail to add those extra funds, then at the end of your tax year the Internal Revenue Service will call the missing 20% a distribution -- even though you never intended to receive any distribution. Yikes! What's more, you will pay a 10% penalty if you're younger than 59 1/2.
You would then have to declare the withheld 20% as income for the year despite the fact that Uncle Sammy has been holding it all year for you. In effect, you've really made an advance payment on your income tax bill. While it probably will be refunded (at least in part) based on your overall tax situation for the year, you really don't want the government playing with your money for half a year or so. Arranging for a direct transfer solves that potential problem: Nothing is withheld by your employer for taxes, and 100% gets into your IRA lickety-split.
As a side issue to the direct transfer, be aware that some plans will insist on mailing you a check for plan proceeds instead of sending one to your selected IRA provider. If your plan is one that does -- please, please don't panic. I know we've just described receiving a check made out to you as an Excedrin-level headache, but take a few deep breaths, and remain focused -- for all is not lost. Just make sure the check isn't made out to you. You don't want a check that shows the payee as "Bea Fool." Instead, make sure that it is issued to show the payee as "ABC Brokerage Services, F.B.O. Bea Fool" or some other way that's acceptable to your IRA provider. Ask your IRA provider how the check should be issued to be sure, and then provide that information to your plan benefit administrators.
The key point is you do not want the check made out in a way that would allow you to cash it. If the check is written in any way such that you could immediately take it to the local "Chex 'R Us Check Cashing and Nose Piercing" outlet and get your loot, the IRS will send a couple of guys in suits to your house and tell you that you have had "constructive receipt" of the money. This would put you right back into the 20% withholding problem discussed previously. As long as the selected IRA provider is the clear payee, the check may be physically handed or mailed to you with no problems as a result. All you have to do is send it on to your IRA folks. Not having it mailed directly might be a little annoying, but it's a lot less annoying than having to cut a check to the IRS later in the year.
Think About Keeping Your Rollover IRA Separate From Other IRA Accounts
One last item: If there is even a remote possibility that at some point in the future you may wish to transfer this money to a new employer's qualified retirement plan, you should not mix these funds with any other IRA you may have. Also, you should not add anything else to the rollover IRA you establish for these funds. That way the proceeds and all earnings retain their eligibility for a later transfer to a new employer's retirement plan.
Put the funds being rolled over from an ex-employer into an existing IRA or add any other funds to this sum, and the IRS will say the money is now "tainted." Apparently any money you add to your rollover IRA or already in an existing IRA will cause 401(k) rollover money to smoke or drink or start chasing boys or something. Don't worry, we don't understand where the IRS is coming from on this "tainted" thing either. But the upshot is that your money will be ineligible for a rollover to a future employer's plan.
To Fools, this is not a terribly important point. We believe we can invest these funds to earn more than in an employer's plan anyway -- the best possible choice that an employer would likely provide in its retirement plan would be an index fund, and you, dear Fool, are perfectly capable of acquiring one of those on your own.
Still, at least now you know the rules for keeping your rollover money "pure."
At long last the money is in an IRA. We turn now to the next problem, Investing Your Nest Egg Foolishly.