Q: I am receiving a lump-sum distribution from my former employer’s 401(k) plan. Can I transfer this amount into an IRA?
A: Yes, most retirement plans allow you to transfer your retirement plan funds to your own self-directed IRA upon retirement or other separation from service. This rollover is tax-free and further defers the tax on the lump sum while allowing continual tax-free buildup. The rollover can be accomplished either by a direct, trustee-to-trustee transfer from your plan to your IRA, or by a distribution to you and a transfer from you within 60 days to a rollover IRA.
Direct Rollover
In most cases, your best strategy is to make a direct rollover. This is a direct transfer of funds from your employer-sponsored plan to your IRA. As a trustee-to-trustee transfer, the administrator of your employer-sponsored plan may send the check right to the trustee of your own IRA. In this manner, the money never passes through your hands. Alternatively, the plan administrator may give the check to you to deliver to the IRA trustee. This also qualifies as a direct rollover as long as the check isn't made payable to you. Instead, it should be made payable to the IRA trustee for your benefit. A direct rollover will avoid undesirable tax consequences and possible penalties.
Indirect Rollover
While not preferred, you may also make an indirect rollover, whereby the check is made payable to you. Once received, you will have 60 days in which to deposit the funds in your IRA. However, before releasing your plan funds to you, the plan administrator is required to withhold 20 percent of the taxable amount for federal income tax. To make sure you roll over the correct amount of the lump sum, you must replace this 20 percent out of your own pocket. If done correctly, you will avoid tax on the lump sum and receive the full amount withheld for taxes when you file your annual income tax return.
Roth IRA Conversion
You can roll your distribution into either a traditional IRA or Roth IRA. If you roll the funds over into a Roth IRA (a "conversion") you'll include the taxable portion of the distribution in your taxable income in the year you roll the funds over. A special rule applies to 2010 conversions only--you can elect to report all of the resulting income on your 2010 federal income tax return, or you can instead report half on your 2011 return, and half on your 2012 return.
Count on Your CPA
As you start your adult financial life, it’s a good idea to get to know your local CPA. He or she can help you understand your choices and make the best decisions for your financial future. You may contact me at (409) 892-0233 or (409) 883-5306. My email address is brad@ekc-cpa.com.
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