Avoiding Retirement Plan Distribution Tax Pitfalls

If you’re thinking about retiring or leaving your current employer, you would be required to take a distribution from your employer’s retirement plan. Depending upon the terms of the plan as well as your age, a distribution may not be required immediately.  However, it is important that when you do have to take the distribution that you are aware of a potential number of tax pitfalls that you might incur.

The following information will assist you in determining potential hazards as well as how to avoid them:

If you do not transfer or roll the distribution over into another employer’s qualified plan or an IRA, the entire taxable amount of the distribution will be included in your taxed income for the year of the distribution. Also, at the time of the distribution if you are under 59-1/2 years of age, you may also be subject to a 10% early withdrawal penalty on the taxable portion of the distribution.

There is a huge different between rolling over the distribution and having it directly transferred to another qualified plan or IRA account. A rollover is when you would actually takes possession of the funds and then, within the statutory 60-day limit, deposits the funds into another qualified plan or IRA.  A direct transfer is when the administrator (trustee) of your employer’s plan transfers the funds directly to another qualified plan or an IRA in a trustee-to-trustee transfer for you.

Keep in mind that taking possession of the funds and then rolling them over to another plan exposes you to a couple of substantial hazards.

• The first potential problem occurs when you fail to get the funds deposited into a new plan within the 60-day limit. In that case, the entire distribution will be taxable (except for the amount equal to the employee’s after-tax contributions, if any) and the taxable amount may also be subject to the 10% early distribution penalty.
• The second problem can occur because your employer is required by law to withhold 20% of the distribution for federal income taxes. Therefore, when it comes time to roll the funds into another plan, you would only have 80% of the funds needed to complete a tax-free rollover. If you do not have other funds to make up for the 20% withheld, 20% of the distribution will become taxable. Of course, the amount that was withheld is claimed as federal income tax withholding when you file your tax return for the year. However, depending on your overall taxable income and tax bracket, the amount withheld from the retirement distribution may not be sufficient to cover all the tax liability on the non-rolled distribution, especially if the 10% penalty also applies.
• Keep in mind that when the funds from the retirement plan are transferred trustee-to-trustee to another qualified plan or IRA, there is no withholding requirement, the employer can transfer the entire amount to the new plan, and you incur no tax on the transferred amount until it is withdrawn at some later date.

Remember, it is never a good financial or tax move never a good financial or tax move although, sometimes, a current financial need will make it necessary. The distribution will always be taxable (or partly taxable if the employee made post-tax contributions to the plan), but there are exceptions that may allow you to avoid all or part of the penalty.

If you have already taken or anticipate taking a distribution in the near future and wish to discuss the tax issues that are related to the distribution, please contact Baldwin Accounting.