Employer-Sponsored Retirement Plan Rollovers: What Are My Client’s Options?
By Mary Hopkins, CISP
When individuals retire or leave their employer, they must decide what to do with the accumulated savings in their retirement plan. Typically, they will roll over the assets to another qualified retirement plan or an IRA in order to keep the assets in a tax-deferred account. If they decide to withdraw the assets, they may end up having to include the distribution amount in their taxable income for the year.
Direct vs. Indirect Rollovers
Individuals should talk to a competent tax advisor to determine which option is right for their situation. But if an individual does decide to roll over her retirement plan assets to a Traditional or Roth IRA at your financial organization, she can do so through either a direct or an indirect rollover. If she completes a direct rollover, a check will be made payable to your financial organization for her benefit, or the funds may be directly sent to your organization.
With an indirect rollover, the client will receive the assets (e.g., through a check made payable to her). The client will then have 60 days to return those assets to an IRA or another employer-sponsored retirement plan. If the client fails to meet the 60-day deadline, any pretax assets distributed may be taxable and subject to the 10 percent early distribution penalty tax. A mandatory 20 percent federal withholding rate also applies to the taxable portion of the distribution. Both direct and indirect rollovers are reported to the IRS.
Rolling Over After-Tax Assets
If an individual rolls over after-tax contributions from an employer-sponsored retirement plan to a Traditional or Roth IRA, the assets will retain their after-tax status. Subsequent distributions from a Traditional IRA will be taxed pro rata: individuals must use Form 8606, Nondeductible IRAs, to determine the taxable and nontaxable portion of their distributions. Individuals must also file Form 8606 to track the taxable portion (if any) of their Roth IRA distributions.
Rolling Over Assets to a Roth IRA
Individuals may also choose to roll over assets to a Roth IRA. Pretax assets that are rolled over from a retirement plan to a Roth IRA are taxable in the year of the distribution. Clients who choose to roll over pretax assets to a Roth IRA should consider their total taxable income during the year and whether they have the means to pay the taxes. Any after-tax amounts rolled over to a Roth IRA will be treated as “conversion” amounts in a subsequent distribution, subject to the Roth IRA ordering rules.
A client who has designated Roth contributions in an employer-sponsored retirement plan may directly roll over the assets to another designated Roth account or to a Roth IRA. Designated Roth accounts and Roth IRAs have separate five-year waiting periods when determining qualified versus nonqualified distributions.
A qualified designated Roth account distribution that is rolled over to a Roth IRA is treated as regular contributions in the Roth IRA. But if a designated Roth account distribution is nonqualified, the amount representing designated Roth contributions is treated as regular contributions in the Roth IRA, and the earnings portion of the rollover is treated as earnings in the Roth IRA.
Roth IRA distributions are subject to certain ordering rules. Regular contributions are distributed first and are tax- and penalty-free. Conversion and retirement plan rollover assets (excluding rolled over designated Roth account assets), are distributed next (by year, with taxable assets distributed before nontaxable assets). Each rollover and conversion has its own five-year waiting period. If the taxable amount converted from an IRA or rolled over from a retirement plan to a Roth IRA is distributed within five years of the conversion or rollover, a 10 percent early distribution penalty tax will apply unless the IRA owner qualifies for a penalty tax exception.
Finally, any earnings that have accumulated in the Roth IRA are distributed after all contributions and all conversions and rollovers have been distributed. Until “qualified” status is reached, any earnings would be taxable and subject to the 10 percent early distribution penalty tax unless a penalty exception applies.
Qualified distributions from a Roth IRA are always tax and penalty free.
Know the Rules
No matter what your clients decide to do with their retirement plan assets, it’s important to know what type of assets you’re accepting before you complete the transaction. If you’re unsure, contact the client’s plan administrator or request additional paperwork from the plan to be certain. IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), offers additional information on rules about employer plan rollovers, including a rollover chart on page 22 that will show you what types of rollovers are permitted between various types of plans and IRAs.
