Setting up Your Rollover IRA Distribution

In truth, the phrase “Rollover IRA Distribution” is a bit of a misnomer. A distribution is vastly different from a rollover and, in fact, this type of transaction really undercuts the whole process. However, there’s a way to set up a rollover from one IRA to another that preserves your retirement investments, but it must be separate from a distribution in order to maintain the tax deferred status of your savings. Continue reading

Which Rollover IRA Option is Right for You?

A rollover IRA allows you to consolidate all of those old accounts into one new one, making it easier to manage your investment options and plan for retirement.  In addition, most rollover IRA accounts offer a wider range of investment opportunities than your old employer’s plan Continue reading

Rollover IRA–Dos and Donts


Rollover IRA is a term assigned to an IRA account that has been increased by adding funds from an employer sponsored plan.  The most common incidence occurs when you retire or change jobs and move the funds from the employer-sponsored plan, such as a 401k plan, to your own IRA.  In fact, you don’t need to set up a new or separate IRA to accept these roll over funds from the 401 plan.  You can simply add funds from an employer-sponsored retirement plan directly to an existing IRA.

Avoid the 20% Withholding
When you retire or change jobs, your employer will give you a form asking how you want them to distribute your 401k account.  If you have them send a check payable to you, this is a big mistake as the employer must withhold 20% from your balance which they must remit to IRS as a pre-payment against your federal income tax.  |

While that may sound okay at first, this creates a big problem. You have a check sent payable to you and 20% is withheld.  Say you had $100,000 in the 401 plan and after the withheld tax, you now have retirement money of $80,000 in your hands.   If you deposit the $80,000 into a rollover IRA within 60 days of receiving the check, then you will have completed a tax free rollover for $80,000 but you will owe federal and state income tax on the remaining $20,000 which did not get rolled over.  You may complain that it’s impossible to roll over the other $20,000 as your employer kept it (actually, they withheld it and sent it to IRS for your current year’s estimated tax).   But that’s your problem.

If you don’t have $20,000 of your own funds (e.g. in your checking or savings account) that you can add to the $80,000 and complete a 60 day rollover of the entire $100,000 distributed form your 401k, you will owe tax on the $20,000 you do not rollover (about $6,000 tax on average).  Note that next April 15, you have already paid $20,000 toward your federal taxes (the money your employer withheld) and you may get a nice refund.  But that won’t help today if you don’t have the $20,000 right now to make your rollover completely tax free.

To avoid the 20% withholding, an IRA rollover must be a direct rollover (also known as a trustee to trustee transfer). This means the distribution check from the retirement plan at your old company must be made out in the name of the trustee or custodian of the IRA account that you want to receive the rolled over funds. You simply need to fill out correctly the form provided by your ex-employer. Your $100,000 will now be sent directly from your 401k plan to your rollover IRA account with no withholding.

When a Rollover IRA May Not be the Best Option
If you hold company stock in your company retirement plan, you may be better off withdrawing the shares and holding them in a taxable account instead of rolling them over into an IRA. (You can still roll over everything else.) Assuming the shares are received as part of a lump-sum distribution (usually this means a complete liquidation of all your company retirement accounts in the same calendar year), you’ll be taxed only on the amount the plan paid for the stock. For example, you may have accumulated shares over the years at an average of $20 per share (IRA calls this the basis) and let’s say the shares are worth $100 today. Paying ordinary income tax on this small basis could a relatively small amount and doing so allows you to defer tax on any appreciation and pay it later at capital gains rates.

The tax on the basis today is at ordinary income rates (which can be set as high as 35%), but here’s the benefit: The net unrealized appreciation when the shares are distributed to you (the difference between the market value, $100, and the plan’s cost for the shares, $20 in our example) will qualify for the 15% maximum long-term capital gains rate (0% if you’re in the 10% or 15% rate bracket). Even better, that capital gains tax is deferred until you sell the shares. Any additional appreciation also qualifies for the 15% rate if you hold the shares more than 12 months before selling. Note: the rates above are rates in effect on 2010.

Last but not least, if you die while still owning the shares, your heirs will get a basis step-up for all appreciation after the shares come out of your retirement account up to the date of death. This means that appreciation never gets taxed (based on current rules which can always change). If you ignore this special tax break for company shares held in a company retirement plan and  you roll the shares over into an IRA, you or your heirs will eventually pay tax at ordinary rates — up to 35% — on all these gains when withdrawals are made from the account. And there’s no break for your heirs if the stock is still in your IRA when you pass away.

Case Study

Jackie is just retired and has company stock in her profit sharing plan. The cost of the stock was $200,000. But it is worth $1 million now. If she were to rollover the $1 million to an IRA, the money would grow tax-deferred until she took distributions. At that time, the withdrawals would be taxed as ordinary income. When Jackie dies, her beneficiaries will pay ordinary income tax on all of the money they receive.

But if Jackie withdrew the stock from the plan rather than rolling it into her IRA, her tax situation would be different. She would have to pay ordinary income tax on the $200,000. However, the $800,000 would not be taxable. And she will not have to worry about required minimum distributions. If she eventually sells the stock, she will pay the lower capital gains tax on the net unrealized appreciation (NUA) and any additional appreciation.

Jackie’s beneficiaries will not receive a step-up-in-basis for the NUA. However, they will only pay at the capital gains rate. And appreciation between the distribution date and the date of death will receive a step-up-in-basis; therefore will pass income tax free.

With NUA                           Without NUA
35% Tax on $200,000    $70,000     35% Tax on $1 million    $350,000
15% Tax on $800,000    $120,000

Total Tax              $190,000                             $350,000

Let’s assume the value increased to $1.5 million in five years, and she decided to sell.

                   With NUA       Without NUA
Taxable Amount    $1.3 million    $1.5 million
Tax Rate           15%             35%
Potential Income
Tax to Jackie     $195,000
Plus Amount
Previously Paid   $70,000
Total Tax         $265,000        $525,000

Finally, assume that Jackie died in five years after the stock increase to $1.5 million. What would her beneficiaries have to pay?

                   With NUA                     Without NUA
Taxable Amount     $800,000                     $1.5 million
Tax Rate            15%                          35%
Income Tax         $120,000                     $525,000
Amount Receiving
Step-Up in Basis   $500,000                      0

Learn more.  Get your free copy “Six Best and Worst IRA Rollover Decisions