A Checklist for IRA Rollovers

In 2015 we have been looking at retirement plan issues for various life stages. In this article: a checklist for those who have decided to do a rollover from a company plan to an IRA.

Caution: If your distribution includes "employer stock," or is eligible for any "grandfather rule," additional considerations apply! In those cases do not rely on this checklist. See "Where to Read More," below.

Aftertax Money--Also Called "Basis" or "Investment in the Contract" If the employee has aftertax money in any of his accounts in the employer plan, leaving the job is an ideal time to roll that money tax-free directly into a Roth IRA. A recent IRS rule change permits the departing employee to instruct the plan administrator to send the "pretax money" via direct rollover to a traditional IRA (thus to continue deferring income tax on it) and the "aftertax money" via direct rollover, separately, to a Roth IRA. Since the IRS formerly said this was impossible to do, this 2014 flip-flop in their position is a welcome change.

Do not overlook this unique opportunity to get a Roth IRA "tax-free!" The only reason not to take advantage of this is if you know you need the cash immediately for some reason, in which case the new IRS rules allow you to have the aftertax money paid to yourself (tax-free of course) separately, while sending the pretax money via direct rollover to a traditional IRA.

Plan Loans Do you have a loan outstanding from the plan? If at all possible, pay it off prior to rolling the money out of the plan. Otherwise, the plan will deduct the loan balance from the account balance and roll over only the net amount--with the loan balance being treated as an income-taxable distribution. Paying income tax on a distribution is especially unwelcome when you don't receive any cash, just a bookkeeping entry telling you your loan is paid off.

If you forget this step, and find the plan has treated the loan balance as a distribution, you can still "roll over" that phantom income amount by using "substituted funds," within 60 days after the distribution, to eliminate the taxable distribution.

Life Insurance If the plan holds a life insurance policy, the policy normally must be removed from the plan when you retire. This event is called the "rollout." There are three choices:

1. Take the policy out of the plan as a distribution. Its fair market value (minus any "basis" or "investment in the contract") will be treated as a taxable distribution, so you'll have to pay income tax, and lose further deferral, on that income (because a life insurance policy cannot be rolled into an IRA).
2. The plan can surrender the policy to the insurance company, so your account gets its cash value, which can then be rolled to an IRA. But you lose the insurance coverage.
3. You can buy the policy from the plan, so now your plan account is all cash and can all be rolled into an IRA. This approach requires you to come up with enough cash to pay the plan for the policy.

Complications and special rules apply to each alternative, so further reading is required.

Spousal Consent Under many (not all) employer retirement plans, federal law requires the employee's spouse to consent to allow the employee to take money out of the plan in any form other than a "qualified joint and survivor annuity" with the spouse. Be sure that spousal consent, if required, is properly obtained. Your lawyer should review the consent form; it is not unheard of for an employer's consent form to "flunk" the statutory requirements, opening the door for a spouse to contest the transaction later!

Direct Rollover vs. 60-Day Rollover There are two ways to get a "tax-free rollover" from the qualified plan to a traditional IRA. One is to have the employer plan send the funds directly to your IRA custodian or trustee. This is called a direct rollover. The other is to have the plan distribute the money to you, and then you deposit the money in a taxable account and write a check to the IRA custodian or trustee within 60 days, thus "rolling over" the distribution.

When assets move from a qualified plan to an IRA, both of these methods are considered "rollovers" for most purposes of the Tax Code, but they have different rules and effects.

For one thing, when the plan distributes assets to a recipient who could have elected a direct rollover for those assets, the plan must withhold 20% of the income-includible portion of the distribution and send it to the IRS as withheld income taxes. In this case, if you cash out your plan benefits upon retirement, you will not receive 100% of the account--you will get the aftertax money plus 80% of the pretax money. So one significant advantage of the direct rollover is avoiding the mandatory income tax withholding. (If you overlooked this point and took a cash distribution, and want to roll over the entire distribution, you can roll over the withheld part by using "substituted funds.")

The main drawback of the 60-day rollover is the 60-day deadline. Every week the IRS issues several private letter rulings dealing with taxpayers' desperate requests seeking a hardship waiver of the 60-day rollover deadline. Taking your distribution in cash seems to be a trigger for catastrophe--the participant or a family member suffers serious medical problems, a building burns down, or a typhoon sweeps through. It is very easy to miss the 60-day deadline. Avoid the risk by using a direct rollover instead!

A final advantage: A 60-day rollover shows up on your tax return as a retirement plan distribution (line 16a of Form 1040), even though the taxable portion of the distribution (line 16b) is zero. The direct rollover does not show up at all on your tax return. Some people find that exclusion helpful when dealing with college financial aid officers or others interested in knowing their income.

To do a direct rollover, set up the recipient IRA account first, before requesting a distribution from the plan. Triple check the paperwork before submitting the request to the plan administrator. Typically, you will receive the plan's check, even though the check is payable to the IRA custodian or trustee (so you couldn't cash it even if you wanted to). You then have the responsibility to ferry the check over to the IRA custodian or trustee to complete the direct rollover.

Income Tax Withholding There is no income tax withholding for a direct rollover (see above), so in that case you don't have to worry about the withholding of federal income tax. In some cases, employees will want to proactively use withholding as a way to make sure their income taxes get paid. In that case, they can allow statutory withholding to occur or they can request withholding from the distribution in a larger amount.

Get Professional Help Finally, employees are strongly advised to get professional help to complete the rollover--either an estate planning attorney, accountant, or financial planner should oversee the process. This should add professional expertise to make sure everything is done correctly, but also ensures that (if any mistakes are made) the employee will have some recourse.

Where to Read More Regarding distributions of employer stock (not covered in this checklist), see ¶ 2.4 and ¶ 2.5 of Life and Death Planning for Retirement Benefits.

Regarding "grandfathered" distributions (not covered in this checklist), see the author's Special Report: Ancient History, downloadable free at http://www.ataxplan.com.

Regarding the "tax-free Roth conversion" of aftertax money in a qualified plan, see the 2015 update of the author's book Life and Death Planning for Retirement Benefits (7th ed. 2011) posted (free) at http://www.ataxplan.com. These new rules are already incorporated into the electronic edition of the book.

For income tax treatment of plan loans upon retirement, see ¶ 2.1.07 of Life and Death Planning for Retirement Benefits.

For rules regarding life insurance in a qualified plan, see the online version of Life and Death Planning for Retirement Benefits at http://www.retirementbenefitsplanning.com (Chapter 11) (which does not appear in the print edition), or the author's Special Report: When Insurance Products Meet Retirement Plans, downloadable at http://www.ataxplan.com.

Regarding the spousal consent rules, see ¶ 3.4 of Life and Death Planning for Retirement Benefits.

For rules on income-tax withholding from retirement plan distributions, see ¶ 2.3 of Life and Death Planning for Retirement Benefits.

This article originally appeared on MorningstarAdvisor.com. Click here to read more from Natalie.

Now available in electronic edition! By popular demand, Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011) has been published in an electronic version. The e-book edition gives you the entire book in word-searchable format, PLUS two additional chapters (on life insurance and annuities in retirement plans) that were left out of the print edition for reasons of space. Updates for the new 2015 rollover rules are already incorporated into the e-book. And, of course, you get the convenience you expect from an electronic format: word-searchable text, live links to cross-referenced sections, and access anywhere you have an Internet connection. Only $9 per month, cancellable at any time. Visit http://www.retirementbenefitsplanning.com to subscribe or learn more.