Millions of Americans have switched jobs during the coronavirus pandemic. Beyond that, some 12,000 baby boomers have been entering retirement every day, which has led to a flood of 401(k) rollovers. Along the way, many workers will make one or more of the following seven 401(k) rollover mistakes.
The result of a 401(k)-rollover mistake can be a huge tax bill, especially if the failed rollover is substantial, which is often the case when an entire 401(k) balance is being rolled over. While these seven mistakes are common, they can be avoided.
1. Missing the 60-day rollover deadline
I almost always recommend my clients do direct rollovers from a 401(k) to an IRA. If you find yourself doing an in-direct rollover, make sure you don’t miss the 60-day window to get the money back into an IRA or 401(k). I just spoke to someone who missed the deadline, which ended up costing them more than $500,000 in unnecessary taxes and penalties.
2. Required Minimum Distributions (RMDs)
RMDs can never be rolled over, yet error is commonly made. If an RMD gets rolled over, it becomes an excess IRA contribution subject to the six percent penalty unless it is removed by October 15 of the year following the year of the excess contribution.
3. Hardship Distributions
Some 401(k) plans will allow for hardship distributions. This topic came up quite a bit during the past year and the Covid Recession. However, hardship withdrawals cannot be rolled over. The withdrawal is meant to help your finances during an emergency. The hardship withdrawal will be taxable but also subject to the 10% early withdrawal penalty if no exception applies.
4. Unpaid Plan Loans
When you leave your employer, you tend to stop making payments on a 401(k). Eventually, the loan will need to be paid back, or the remaining balance will be deemed a distribution. The 401(k) plan will report the outstanding loan balance on Form 1099-R. A deemed distribution is taxable and may be subject to the 10% early distribution penalty.
5. 72(t) Distributions
Sorry to use jargon here, but these retirement account withdrawals are known as 72(t) distributions. Basically, it is a retirement income strategy (for those who retire earlier than 59.5) to avoid the 10% early withdrawal penalty.
To avoid the early withdrawal penalty, the retirement account withdrawals must be a series of substantially equal periodic payments. You get to tap your 401(k) (assuming you are no longer working for the employer) or an IRA before age 59½ without the annoying 10% penalty. You must commit to a plan of withdrawals according to the rules set out in Section 72(t)(2)(A)(iv) of the Internal Revenue Code. Retirees can begin a 72(t) payment schedule from an IRA at any age, even if they are still working. The withdrawals must continue for at least five years or until age 59½, whichever period is longer. These distributions cannot be rolled into another retirement plan.
Before setting up a 72(t) plan, you must be aware of a few additional rules you need to follow. You may not modify the agreed-upon schedule or account. If you violate this contract, then the 10% penalty will apply to all distributions taken prior to age 59 ½. This is known as the recapture penalty, which can be a substantial tax hit.
6. You Must Rollover Like Property
When you withdraw cash from your retirement account, then only cash can be rolled back over into another retirement account. If you withdraw stock from an IRA, then only that stock is eligible to be rolled back over. It must be the same property; otherwise, it cannot be rolled over.
For indirect 60-day rollovers for an IRA-to-IRA or Roth-to-Roth, the same property received is the property that must be rolled over. For example, an individual could not receive a distribution of cash and then roll over shares of stock that he purchases with the cash or that he currently owns in a non-retirement investment account.
7. Divorce
Take care when splitting a retirement account during a divorce. When IRA funds split in a divorce are withdrawn, those funds are taxable and cannot be rolled over to the ex-spouse’s IRA. Trying to do so is a common and very expensive mistake. Divorce attorneys handle divorces. They may not be giving you the best tax planning advice or even investment guidance.
To avoid these tax consequences during a divorce, 401(k) and IRA funds should be moved from one spouse’s IRA to the other’s via a tax-free direct transfer. This is often done via QDRO (Qualified domestic relations order).
While these 401(k) rollover mistakes are annoyingly common, they are easy to avoid. If you are unsure of how to proceed with an IRA rollover, work with a trusted fiduciary financial planner to help guide you through this process.