Last week, we started a discussion about one of the biggest financial assets for many people — their qualified money. This week, we are going to look at ways to avoid some common mistakes when dealing with these funds.
Many people take their 401(k), 403(b) or TSP and roll them over into an IRA at retirement. This change may give you more investment options and flexibility.
When this is done, the best way is to do a trustee-to-trustee transfer. This is when the money moves without you taking procession of it. This avoids three potential pitfalls. First, if the check is made out to you, you have 60 days to complete the transfer or the whole amount will be considered taxable to you. This mistake might bump you up several tax brackets, you would lose the advantage of tax deferral and it might make your Medicare more expensive.
The second possible pitfall would be your trustee would be required by law to withhold 20% of the total for taxes. If you were to open the new account within 60 days, you would have to make up this 20% tax withholding with other money. When you filed your next tax return, you would claim a refund for the difference. This may be a significant amount of money.
The third challenge is you are only allowed to have one transfer sent to you every 12-month period. If you mistakenly do a second one, the whole amount is immediately taxable. There is no limit to the number of trustee-to-trustee transfers that can be done in a year.
The rules are stricter when rolling an inherited IRA over to a non-spousal beneficiary. Remember, only a spouse can make an inherited IRA their own. If a spouse has the funds sent to them, they have 60 days to complete the transfer. If a non-spouse does this same thing, it is immediately taxable. All non-spousal inherited IRAs must be made trustee-to-trustee.
Usually the rules for taking distributions from inherited 401(k)s are determined by the tax code, some plans are more restrictive. They may require a shorter time frame to make decisions or accelerated distributions. Be sure to check the plan to determine the rules. The written information is available in the summary plan description (SPD), which is the “plain language” version of the rules governing the 401(k).
It is a mistake to take the distribution as a lump sum when you are planning to stretch the qualified money. This is often caused by giving incorrect instructions to the plan administrator. For example, you should not ask for a distribution from the inherited IRA. Instead, you should ask for a direct rollover.
You must be very careful when handling situations with inherited qualified money. It can leave a lasting legacy or it could create some short term nightmares. As in all financial matters, careful planning is the key to a successful outcome.
Your Financial Future is written by certified financial planner Gary W. Boatman, MBA and CFP, who also wrote the book, “Your Financial Compass: Safe Passage Through The Turbulent Waters of Taxes, Income Planning and Market Volatility.” If there is an area that you would like to see discussed in the column, send your suggestions to gary@BoatmanWealthManagement.com.