How An Indirect Retirement Account Rollover Can Go Wrong And How To Avoid It
September 11, 2018Late last week I received a panicked phone call from my sister. She had received an unsolicited check from a financial institution with no letter explaining what it was for or why she received it.
After we did some investigating, it turns out it was a full distribution from her traditional IRA because the mutual fund it was invested in had been closed by the fund company. Because she did not want to take a distribution from her IRA, she will need to deposit that check into another traditional IRA within 60 days to avoid paying taxes and early withdrawal penalties (she is not yet age 59 ½) on the amount of her IRA.
While a hassle, that process is not difficult or time consuming. But here’s the rub: the fund company withheld 10% for federal income taxes. We’re not sure why 10% was withheld as it is not required to withhold from an IRA, but it is important to note that distributions from an employer plan, like a 401(k), require 20% mandatory withholding for federal taxes.
Why the unnecessary withholding is an issue
To avoid taxes and penalties on the amount withheld, she will need to come up with that 10% amount to make the indirect rollover a complete rollover. Otherwise, she will incur taxes and penalties for the amount withheld that won’t get into the new IRA within the 60 day deadline.
Let’s break it down further
The details
For simplicity sake, I am going to use round numbers to illustrate the problem.
- The full amount of the distribution was $50,000.
- $5,000 was withheld, so my sister received a check payable to her for $45,000.
- If she were to simply cash that check, she’d have to include the full $50,000 as taxable income to her this year, including an additional 10% penalty for the early distribution (maybe that’s why they withheld? We’ll never know).
- She is not able to come up with an extra $5,000 to complete the full $50,000 indirect rollover into an IRA, so her new IRA will start with a value of $45,000 – down from the $50,000 she had last week.
- Come tax time, the $5,000 withheld will be included as income on her tax return. Even worse, she will have to pay a 10% early withdrawal penalty on that $5,000!
- If she is in the 22% tax bracket, that comes up to $1,600 (22% times $5,000 plus 10% times $5,000) in tax and penalties.
- She will get a refund of $3,400 since the tax and penalty on the $5,000 withheld is only $1,600. But she has now lost over 3% of her IRA value as well as the future tax-deferral on that $5,000.
A unique situation
This is a unique situation – having a distribution happen with no warning or chance to act beforehand (I suspect something was received and discarded on accident, but that is neither here nor there) – but I can only imagine that other recipients of such checks who did not have a financially savvy person to call may have just cashed the check and will find themselves with a big tax surprise in April.
What could’ve been done differently
Had she known this was going to happen, she could have initiated a direct rollover – where the funds move directly from one financial company to another – with no tax implications at all. And no need to worry about getting the funds into a new IRA within 60 days.
The moral of the story
Besides opening your mail and making sure you’re not missing important communications from your financial services providers, the important take-away here is that the simplest way to move retirement money is to avoid being the middle person. If possible, a direct rollover will always be much better than an indirect rollover if your intention is to keep all the funds in the IRA for the future.
This is especially true when rolling funds out of your 401(k) or other employer-sponsored retirement plan, as an indirect rollover does lead to a mandatory 20% tax withholding. When you do a direct rollover, there are no taxes to be withheld, so you don’t have to make up the difference (assuming you have the cash available to do so) or get stuck with unintended income.