Know your Options before Deciding

Whether you retire, resign, or are forced to part ways with an employer that has provided a retirement plan, you have to take your money out of the plan. The distribution, as it’s called may not need to happen immediately – this depends upon the terms of the plan, as well as the age of the employee. Regardless of when it happens, it is essential that you understand all of the tax implications of the distribution that you take in order to avoid making some big mistakes and owing more than you should.

The most important thing for an employee who has taken a distribution to remember is that if they don’t transfer or roll the distribution over into another IRA or a qualified plan with their new employer, then the entire amount will be considered taxable income for the year that it was received. 

To add insult to injury, if the employee is under the age of 59 ½ when the distribution was taken, they’ll also be facing a ten percent early withdrawal penalty on whatever portion of the distribution is taxable.

In most cases, employees will rollover the distribution into another qualified plan within an established statutory 60-day limit in order to avoid the tax issue.  However, a rollover is very different from a direct transfer – when a rollover takes place, the funds are first given to the individual and then redeposited into the new account.

When a direct transfer occurs, the administrator of the original employer plan moves the funds into the new plan on behalf of the departing employee: This is a trustee-to-trustee transfer.

There are certain risks involved with rolling the distribution over. The most obvious potential problem is if the employee fails to complete the process of depositing the funds into a new plan within the sixty day time period. 

If that should happen their tax exposure would be for the entire distribution (less any after-tax contributions that they made). Additionally, the amount would be subject to the ten percent early distribution penalty if the employee is under the age of 59 ½. 

There is an additional complication that comes into play – federal tax law requires the employer to withhold twenty percent of the distribution to pay for taxes. That means that even if the employee does carry out the rollover in a timely manner, the deposit into the new account is only eighty percent of the full amount expected for a qualified rollover. For those employees who do not have the cash reserves required to compensate for the twenty percent that the employer withholds, then that twenty percent will be subject to tax.

If the employee falls victim to this issue, the twenty percent that has been withheld will be applied to their federal income tax withholding for the tax year, but it is not at all certain that the amount held back will be enough to pay all of the employee’s tax liability, particularly when the ten percent penalty is taken into account. This will be largely dependent upon the employee’s tax bracket and the amount withheld.

The hazards posed by the rollover are completely eliminated when the employee opts for a trustee-to-trustee deposit into a qualified plan or IRA. The employer has no obligation to withhold twenty percent and can transfer the entire amount, and there is no risk that the employee will miss the sixty-day deadline.

Employees are often tempted to take the money from their retirement plan to use for current needs. This is an ill-advised move, but is sometimes a financial necessity. When they do so, they will automatically be subject to tax on the taxable portion of the distribution, though there are certain circumstances in which the penalty may be waived.

For more information on distributions of an employee retirement plan, please call our office at 909-949-4898 and set up an appointment. Having the right information and guidance. can prevent you from making costly mistakes.

If you have questions concerning the tax ramifications of your retirement distribution, contact Gordon McNamee at (909) 949-4898.