Rollovers allow you to enjoy the continued growth of your tax-deferred retirement assets, even when the world around you is changing.
A rollover involves the tax-free transfer of all or part of your qualified retirement plan assets (known as distributions), either in the form of cash or another form of property (such as stocks) either to an individual retirement account (IRA) or to another qualified retirement plan, provided that (a) the amount of funds transferred from the old account/plan to the new one is completed within 60 days, (b) if property is being transferred, the same property must be transferred to the new account or plan, and (c) no previous tax-free rollover has been made in the last 12 months prior to the transfer under consideration. (For more information, see Common IRA Rollover Mistakesand Exceptions To The 60-Day Rollover Rule.)
If you're a participant in a qualified retirement plan and you're taking a new job with a different employer, or you're just not ready to retire and withdraw your funds, using a rollover is a great option. Typically, fund or property/asset transfers are made from one IRA to another IRA, from an IRA to a qualified retirement plan, from one qualified retirement plan to another qualified retirement plan, or from a qualified plan to an IRA. The main types of rollovers are the conduit IRA, the direct rollover, the indirect rollover, the spousal beneficiary rollover, and the non-spouse beneficiary rollover, all of which we cover in this article.
The Conduit IRA
The conduit IRA rollover is an intermediate step and acts as a temporary holding station between IRAs or qualified retirement plans. You can think of it as an airport layover between flights. This type of rollover is usually used when a plan participant is changing employers and moving from one IRA or qualified retirement plan to another.
The conduit IRA rollover offers a number of advantages. For plan participants aged 72 or younger, the conduit IRA preserves your fund's eligibility for forward averaging and favorable capital gains treatment at a future distribution date. If the transfer involves an employer-sponsored plan, the conduit IRA provides you access to low- or no-cost investment advice. If you're an IRA account owner, you may have more leeway in selecting investment vehicles and making investment decisions. Plus, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), conduit IRAs offer greater bankruptcy protection from creditors for amounts exceeding $1 million.
The main disadvantage of the conduit rollover is your inability to access and use the retirement funds in case of an emergency, without incurring taxes and penalties due to IRS restrictions and limitations that apply under IRA rules when retirement funds are transferred from a qualified plan to an IRA account. You may also face a loss of special tax advantages for assets held in employee stock. (To read more, see Supplementing Your Retirement Income With IRAs.)
The Direct Rollover
Under the direct rollover, fund distributions can be transferred from a qualified retirement plan, a 403(b) plan, or a tax-sheltered annuity to another eligible retirement plan other than an IRA (such as 401(K) or another 403(b) or a TSA). This usually involves a direct trustee-to-trustee transfer or another means allowable by the IRS.
The main advantage of the direct rollover is that it allows you to avoid the IRS mandatory withholding rules. A mandatory 20% income tax withholding is applicable to all qualified-plan distributions. If the transfer is not made directly from one trustee to another, the disadvantage is that 20% of the funds will be withheld for income tax purposes. (Learn more about taxes in 10 Steps To Tax Preparation and Five Tax(ing) Retirement Mistakes.)
The Indirect Rollover
An indirect rollover occurs when you receive the asset distribution from a qualified retirement plan instead of it directly being sent to the trustee of another qualified retirement plan. You must roll the distribution over to another qualified retirement plan or IRA within 60 days; otherwise, a tax event will be triggered making the distribution subject to federal income tax, and possible penalties (totaling 10%) may also apply.
One advantage of the indirect rollover is that it offers you the freedom to select investment vehicles. It also allows you to use the retirement funds for 60 days if you have a short-term need for them. Another advantage is that it provides you the flexibility to receive income before the age of 59.5 without penalty by properly setting up a periodic payment program through IRS code 72(t).
At the same time, the indirect rollover has a few disadvantages. For example, your new employer plan administrator may only accept transfers of qualified retirement plan assets; the forward averaging benefit may be eliminated; and you have to pay mandatory federal income tax withholding of 20% of the distribution if the full balance of a qualified retirement plan account is not transferred.
The Spousal Beneficiary Rollover
The spousal beneficiary rollover applies to surviving spouses of qualified retirement plan participants, and it can be implemented in different ways. The retirement assets are either transferred to an account in the survivor's name or maintained in the original retirement account inherited by the survivor with the account re-titled in the survivor's name. Periodic annuity distributions, hardship distributions, or age-70.5 minimum required distributions cannot be rolled over by the surviving spouse. (To learn more, see The Tax Benefits Of Having A Spouse.)
The Non-Spouse Beneficiary Rollover
The non-spouse beneficiary rollover was created by the Pension Protection Act of 2006 (PPA), and it allows for the establishment of an IRA for a non-spouse beneficiary of a qualified plan, tax-sheltered annuity (403(b) plan), or Section 457 governmental plan. The following requirements have to be met:
- The terms of the qualified retirement plan must provide the option to a non-spouse beneficiary to roll over the inherited plan benefits.
- The inherited IRA must be established in the name of the deceased plan participant for the benefit of the non-spouse beneficiary.
- A trustee-to-trustee transfer must be used to implement the assets transfer.
- If the deceased plan participant died before the required beginning date, the transfer to the IRA must be made before the end of the year following the year of the participant's death.
- The retirement plan benefits (distribution) must be paid out over the beneficiary's remaining life expectancy.
- Distribution of the IRA benefits must begin by December 31 of the year following the year of the plan participant's death.
An advantage of this type of rollover is that it allows for the continued tax deferral of accumulation while mandatory distributions are taken over the beneficiary's life expectancy. (To learn why you might want to keep your spousal accounts separate, see Happily Married? File Separately!)
However some disadvantages exist due to IRS's Notice 2007-7, which provides a number of restrictions:
- An employer plan is not required to offer this option to a non-spouse beneficiary unless the plan is terminated, which means that the employer may offer this rollover options but it isn't required.
- A distribution made directly to a non-spouse beneficiary is not eligible for rollover to a beneficiary IRA.
- Participant and beneficiary required minimum distributions are not eligible for direct rollover to a beneficiary IRA.
Each type of rollover provides certain advantages and disadvantages. Exercise caution in selecting the appropriate rollover type, and consult with a financial planning professional to determine the best fit for your individual situation to best maximize the benefits offered under each available rollover option.
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