Watch out for this ‘mandatory’ rule
Dear Dan,
I rolled over my 401(k) last year and my company automatically withheld $15,000 for taxes. I got the remainder (about $60,000) into my IRA way ahead of the 60-day deadline, but my accountant insists that I owe a $1,500 penalty because of the withholding. That doesn’t seem right or fair. What can I do about this?
—Ticked off in Tempe
Dear Ticked,
This happens often in part because the terminology is confusing. Unfortunately, unless an exception applies, I don’t think you can do anything about it if you were under age 59½ at the time the money came out of the 401(k). If you were over age 59½ the penalty should not apply but there is still a tax consequence. Nonetheless, you can prevent this from happening again with future rollovers.
If a distribution is deposited into another plan or IRA within 60 days of receipt, there is no tax. The default for 401(k)s and some other retirement plans is to withhold 20% for taxes from distributions out of the plan. This is called “mandatory withholding,” but it is not truly mandatory as I’ll discuss in a bit. (Note this 20% withholding regime does not apply to distributions out of IRAs.)
What I suspect happened here is that the plan distributed $75,000 but only $60,000 got to the IRA because $15,000 went to Uncle Sam via withholding. The $15,000 withheld was therefore distributed, but not rolled over. Any portion of the distributed amount that are not redeposited in time becomes taxable income and the 10% penalty will apply if you are under 59½. Look closely at your return and you should see $15,000 of taxable income included on Line 5b. Not only are you subject to the penalty, you paid income tax on that $15,000, too.
The taxes and penalty could have been avoided if you had deposited $15,000 from other funds in the IRA within the 60-day window.
The easiest way to avoid this in the future is to do rollovers as “direct” rollovers, also called “direct transfers” or “trustee to trustee transfers.” Direct rollovers enable a transfer with no tax withholding, so all the funds end up in the receiving account. Rolling over funds this way eliminates the issues with both the 60-day clock and the once per 12-month rules that apply to indirect IRA to IRA rollovers.
With a direct rollover the check will not be payable to you. Instead, it will be made payable to the receiving firm and account even if it is mailed to you. These checks would read something like “Payable to XYZ company FBO (for benefit of) the John Doe IRA.”
Though the 20% withholding is described as “mandatory” 401(k) plans must offer the option to perform rollovers as direct transfers with no withholding.
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Originally published on MarketWatch. Read the original article here.