People who are about to retire or change jobs have enough to think about. They don’t need to have someone telling them to avoid a “20 percent penalty.” Yet that’s what a lot of financial services firms, including banks, brokerages and even some mutual fund companies are doing to attract money from retirement plans.
It would be better if they’d stop trying to scare people’s money into their coffers and just dispense information.
Still, everyone with a retirement fund should be aware of the 20 percent rule.
It’s been almost a year-since Jan. 1, to be exact-that the federal government has required employers and anyone else holding money in tax-deferred retirement accounts to withhold for income taxes 20 percent of any money paid to an employee, unless that money is transferred directly from the old employer’s retirement plan to the new employer’s plan, or to the worker’s individual retirement account.
Reasons for the law
The provision was written into a law for two reasons: 1) To encourage people to keep money in their retirement plans instead of using it to buy Porsches, and 2) because the financial services industry lobbied for it as a way to keep billions of retirement dollars in their accounts, rather than having to watch it spent on Porsches. Enlightened self-interest and all that.
Whatever the motivation, the 20 percent rule seems to have worked. Very few workers are taking the money out of their retirement plans themselves. Instead, they are having it transferred into a new employer’s plan, into another 401(k) tax-deferred retirement plan or into a “rollover” IRA.
“I believe most employees are aware of it (the rule),” says Diane Conley of Hewitt Associates, a benefits consulting firm based in Lincolnshire, Ill. “The rule included a requirement that companies tell people about it, so most of my clients have built it into their forms.”
First, a review of the rule: Say you leave a job after saving $10,000 through the company 401(k) plan. If you take the money in a lump sum, you would receive a check for $8,000, even if you intend to put the money into an IRA the very next day. The remaining 20 percent, or $2,000, would be sent to the Internal Revenue Service and applied to the federal tax you might have to pay in the year you received the distribution.
If you still want to put $10,000 into the IRA, you would have to come up with the additional $2,000 out of other funds. Months later, you could claim a refund for the amount withheld.
If you don’t make up the 20 percent, that money is considered a “taxable distribution” from a retirement plan and will be taxed as if it were regular income. If you’re under age 59 1/2, you might also be subject to a 10 percent early-withdrawal tax on that distribution.
Meanwhile, if you don’t put the 80 percent you did receive into another retirement plan within 60 days, the entire amount will be taxed as ordinary income.
Make a direct transfer
You can avoid all this hassle, and keep the money growing on a tax-deferred basis, by having the money transferred directly (often electronically) from your employer’s retirement plan into a new plan or an IRA.
(Caution: if you already have an IRA in which you’re saving some extra money for retirement, don’t attempt to roll your employer plan distribution into it; set up a separate IRA for the rollover. Each IRA will have a different tax treatment, depending on how it was funded.)
First, though, decide where you want the distribution to go. That means picking a bank, mutual fund company or brokerage. That firm should be able to give you the forms you need to start the transfer. Your company benefits office may also be able to provide you with the proper forms.
If you’re changing jobs and plan to make a transfer from your old employer’s plan to the new one, make sure your new employer will accept the money.
Of course, you can always leave the money where it is, in your old employer’s retirement plan or the 401(k). Generally, if your account is more than $3,500, your employer will let you keep the money in the plan. Most companies don’t want to handle the bookkeeping for smaller amounts and can require you to withdraw the money.
Although you can start making penalty-free withdrawals at age 59 1/2, try to put it off. In fact, says James Gately, senior vice president at the Vanguard Group in Valley Forge, Pa., think about not touching the money at all until you reach age 70 1/2, using any non-tax-deferred savings and investments you might have in the meantime.
“Keep that money growing tax-deferred as long as possible,” he says. While penalty-free withdrawals can’t begin before age 59 1/2, they don’t have to start until age 70 1/2.
Finally, be aware that the “rollover IRA” market is “the fastest growing area in retirement planning,” says Stephen Cronin, a senior consultant at Coopers & Lybrand in Boston.
Many mutual funds, brokerages and private consulting firms are clamoring to offer seminars and workshops to retiring workers. Some of the people putting on these seminars receive commissions based on the amount of business they solicit from seminar participants. Others are simply paid by the employer for providing employees with information.
In most cases, you’ll be better off with the latter.
