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Employers of most pension plans are required to withhold a mandatory 20% of your lump sum retirement distribution when you leave their company. However, you can avoid this tax hit if you make a direct rollover of those funds to an IRA rollover account or another similar qualified plan. Failure to rollover the entire amount of your lump sum distribution may result in your paying unnecessary taxes on all or a portion of your retirement payout.
The 20% withheld from your lump sum retirement distribution is a federal income tax prepayment similar to the federal income taxes withheld from your pay check. It is held by the federal government as a credit toward you r tax liability for the year in which your payout was made. You can use that tax prepayment to reduce your tax liability when you file your tax return the following year, usually by April 15th. Or, if you over paid your federal taxes you will be entitled to a refund of the excess taxes withheld.
To avoid the tax hit completely on your lump sum retirement distribution, it is advisable that you contact your investment representative, banker or new employer's retirement administrator before you agree to receive your pension distribution. Establish a rollover IRA account with your investment broker or banker. My firm has established rollover accounts for several individuals. Next, instruct your pension administrator of the company that you are leaving or have left to transfer your lump sum distribution directly to your new IRA rollover account or qualified plan.
When your lump sum retirement distribution is transferred directly from one trustee to another trustee without your ever taking possession of any portion of those funds, you avoid that 20% tax withholding hit. With a direct rollover, your pension funds escape being taxed until some time in the future when you begin to withdraw from that rollover account.
Caution: should you receive a check and it is for only 80% of your retirement funds, you may wind up paying taxes if you do not take some immediate and decisive action.
How severe will that tax bite be if a entire rollover is not carried out? For any portion of your lump sum retirement distribution that is not rolled over within 60 days of receiving your retirement check, you can expect to pay taxes at your tax bracket rate. What's more, if you are under age 59 1/2 at the time you receive your retirement distribution, you will be hit with an additional tax penalty equal to 10% of any amount not rolled over within the required 60 day period. For someone truly concerned about reducing their tax bite and putting their pension funds to work prudently, a botched rollover can be costly.
For example, if you were due to receive a $100,000 lump sum distribution and your former employer withheld $20,000, you'd pay $7,600 (38% tax bracket) in taxes. If you are younger than 59 1/2, you'll be hit with an additional 10% tax penalty equal to $2,000. Your tax bill on your $20,000 will then be $9,600 versus "0" with a complete rollover.
How do you achieve a tax-free rollover when you received only 80% of your funds and you need to rollover 100% of the distribution? Well, the answer is, you must find the 20% withheld amount from some other source. In essence, the funds you rollover must equal 100% of the retirement funds paid out on your behalf. The source of that "missing" 20%, for rollover purposes, is not important so long as you place 100% of your lump sum retirement distribution amount in a rollover account within 60 days of your receiving your distribution check.
Of course, a direct rollover is the easiest method to avoid taxation on your entire lump sum retirement distribution. But, should you find yourself facing a tax bite on your funds because you are unable to rollover the entire distributed amount, try to reduce that tax bite as much as possible. At least rollover the 80% portion of your lump sum retirement distribution. Next, attempt to rollover some portion of the withheld 20%.
The key to a tax-free pension rollover is to keep your pension distribution intact in a rollover account until you reach age 59 1/2. Or, should you absolutely need to tap into your pension funds before then, do so sparingly and wisely.
Denise Lamaute, pension tax attorney and investment banker with Lamaute Capital, Inc.
8383 Wilshire Blvd.
Beverly Hills, CA
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