NEW YORK (CNNfn) - If you want to take your 401(k) with you when you retire, you can either do a "rollover" or a "trustee-to-trustee transfer." Both methods will move your money for you, but only the transfer will save you big tax headaches.|
A rollover occurs when you receive assets from one retirement plan and transfer them to another. It can be from one IRA to another IRA or from your company retirement account to your IRA. The transfer of retirement funds from your company plan - a 401(k), for example - to your IRA is the most common, and that is where the most costly mistakes are made.
The idea is to transfer your company plan funds to your IRA account without triggering a tax. However, if this transfer is done via a rollover there is a chance that your retirement funds will be eroded by a combination of early taxes and penalties. This can result in some or all of your plan money becoming ineligible to ever be rolled over to your IRA.
There are really only two ways to move company retirement plan money to an IRA: a direct trustee-to trustee transfer and a rollover. The preferred method is the direct trustee-to-trustee transfer.
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Direct trustee-to-trustee transfer method
This, as the name implies, is a direct transfer of funds from your company retirement plan to your IRA.
This is not technically a rollover, because a rollover means that the funds were first distributed to you. The direct trustee-to-trustee transfer is the method that is recommended because you cannot trigger an unexpected tax or disqualify the transfer since you never touch the money. It goes directly from your company plan to your IRA.
Trustee-to-trustee transfers are not subject to any tax withholding and are exempt from the one-per-year 60-day rollover rule. This rule states that if you roll over instead of using the direct trustee-to-trustee transfer, you must complete the rollover within 60 days by contributing the distribution from your plan to your IRA within that time frame. You are also limited to one 60-day rollover per year on that money.
By using the direct trustee-to-trustee transfer method you are eliminating this potential problem and you and your pension money will stay out of trouble.
A rollover occurs when your company distributes your plan assets to you. You actually receive a check or stock certificates. Then it is up to you to transfer those assets to your IRA (or to another company's plan) within 60 days after you receive the distribution from your plan.
If you miss the 60-day deadline, you're out of luck. You must report the entire distribution as income. You'll pay income tax on the entire distribution and, if you have not yet reached age 59-1/2, you will also pay a 10 percent penalty on the distribution.
You can do only one 60-day rollover per year, but the year is actually any 12-month period and not necessarily a calendar year. For example, if you receive your distribution on June 1, it does not mean that you can do another rollover as soon as the new year begins in January 2001. You must wait a full year (12 months) until June 1, 2001, to do another rollover of the same money. The one per year 60-day rollover rule applies separately to each IRA you own.
Rollovers get even worse
If you choose the rollover method to move your company pension money to your IRA, you'll be subject to mandatory 20 percent withholding tax. This means that you will receive only 80 percent of your pension money and the rest will be sent to Uncle Sam to pay any tax owed on the transfer.
The problem is that you should not owe any tax. But now, because of the 20 percent withholding tax rule, you'll have only 80 percent of your company retirement money to roll to your IRA. If you roll over only 80 percent, then you'll pay tax and be subject to the 10 percent penalty on the 20 percent that was not rolled over. The only way out of this predicament is to have other, non-pension or non-IRA funds available to make up the 20 percent shortage. If you don't, you'll be stuck paying tax and a possible 10 percent penalty on the 20 percent that was not rolled over.
This is why you should not use the rollover method to transfer funds from your company plan to your IRA. Be smart and use the direct trustee-to-trustee transfer method and save yourself a bundle of tax headaches. You must inform your company that you want a direct transfer and tell them not to make the check out to you. It should be transferred directly to an IRA that you will set up to receive the assets directly from your company plan.