The Rollover Trap

Someone I know called me recently for a bit of advice. She has a small balance in a former employer's 401(k) retirement plan and the plan was exercising their right to force her out. She had several options including

• Transfer the balance to a current employers 401(k),
• Transfer the balance to an IRA, or
• Take the balance in cash.

Each choice has advantages and disadvantages and if she would have asked me first I would have probably suggested she opt for the IRA, but she had already submitted her paperwork to transfer the balance to her current employers 401(k). This is her tale.

Before retirement plan money (the official terminology is tax qualified money) is transferred from one plan to another, the trustee of the new plan must sign a statement to show they are willing to accept the funds. In this person's case, either the new trustee did not sign the statement or the old trustee never received it. The deadline came for the forced distribution and without the acceptance from another trustee the old 401(k) plan defaulted to the option of paying the proceeds in cash directly to the former employee.

In a cash distribution, a retirement plan is required by federal law to withhold 20%. The employee has 60 days to roll that over to another 401(k) or an IRA but if they are not careful they can get caught in a trap because of the withholding.

Let's say the employee had $50,000 in their old retirement plan and chooses to take the cash distribution now and roll it over within the 60 day window. The previous employer sends the employee a check for $40,000 net after withholding the mandatory 20% (in this case $10,000). The employee deposits the $40,000 and then writes a check to their IRA for $40,000 thinking everything is great but when they do their taxes, they are in for a big surprise.

At tax time their CPA asks them about the $10,000 taxable distribution they took from their 401(k). You see, in the eyes of the IRS they withdrew $50,000 from the old 401(k) but only rolled over $40,000 into the IRA! Now they owe income tax plus a $1,000 penalty on the $10,000 they never actually touched! Unless the transfer was done from one trustee to another, the only way to avoid the rollover trap would have been to take $10,000 out of their own pocket and write the check to the IRA for $50,000. When taxes were filed, the $10,000 that was withheld would either reduce their tax liability or increase their refund and eventually it would all even out. Provided you had an idle $10,000 to use.

Imagine if your 401(k) was $500,000. Would you have an idle $100,000 to use?

In this person's case she only needed to take a couple of hundred dollars out of her pocket, but until she called me she had no idea she was about to fall into the trap. Oh, and did I tell you that she called me about 50 days after receiving the original check? Two weeks later and the trap would have already been sprung.

Related reading:

• The Five Biggest 401k Rollover Mistakes
• Why Company 401k Direct Rollovers Are Preferred
• Retiring Or Leaving The Company – How To Properly Do An IRA Rollover

Mouse Trap by billaday

Comments

[dimes]

I hate this idiotic rule, and I'm sure it's not at all explained when people move from one place to another. Why can't they un-withhold the 20% upon seeing that the balance was already transferred elsewhere? It's something that would give me pause about investing in a company's 401(k). Though yeah, I'd immediately roll out my 401(k) into an IRA upon leaving a company.

[Art Dinkin]

Dimes, I hear what you're saying but I have to agree with the government on this.

Before the current rules, people would take out money from qualified plans with the intent of rolling it over. Sometimes the intent never became a reality. At tax time these people would suffer the consequences.

The current system protects these people from making a big mistake they would have to pay for later as well as providing a mechanism for direct transfer.

Why would someone need to do the rollover themselves when the transfer method is available?

[dimes]

Probably because a lot of people don't do their homework. Many times I did see people who got spanked with early distributions and the 10% penalty, which was usually a punishment on top of the 20% withholding.
The transfer method is great when it works, but as you wrote, sometimes it can fail. I'd always rollover into an IRA though, myself. The only problem is that people freak out when they get a 1099-R with a code G on it because they think they must owe taxes, or something.

[Scott Brooks]

Very rarely do individuals with over $100K cash out
their 401k or other retirement plans.

[jamtam]

I thought that IRAs have certain maximums per year (up to $15k depending on the type). So, with this $50k example, if you don't have the $10k around, what should you do?

[Art Dinkin]

jamtam - IRA's do have maximum that apply to contributions of new money into the plan. In the case of a rollover or transfer they do not apply since we are moving money already in a qualified plan. Not adding to it.

As for this example, if you do not have the $10,000 you unfortunately fall into the trap and it will be expensive at tax time. The point is to use a direct transfer whenever possible and then your entire account will move without withholding.