Sidestep tax traps. If a 401(k) rollover is not done properly, your client could be in for a big surprise.
We’ve all heard that our clients will go through three financial phases over the course of their lifetime: the accumulation phase, the preservation phase and the distribution phase. Consider the following guidelines to help your clients eliminate the tax traps that they could potentially fall victim to.
During the accumulation phase, your clients are likely deferring income into a plan like a 401(k). Then when your clients retire, they will need your help to recommend where that money should go as they enter the preservation phase of their retirement. Of course, we all know that the 401(k) rollover is ideal because it allows them to transfer their existing retirement account into another retirement account (usually a low-risk portfolio) without being subject to unnecessary taxes or withdrawal penalties. Because retirement accounts like a 401(k) are funded with pre-tax dollars and grow tax-deferred, that means if your clients take a premature distribution, the IRS will subject them to taxes on that withdrawal. In addition, if they withdraw the money prior to age 59-and-a-half, your clients could also face an additional 10 percent penalty tax.
Helping your clients avoid taxation during the rollover process can be tricky, and there may be complicated-looking forms to fill out, but it isn’t hard if you know the proper steps to take along the way.
Schedule a call with client and plan administrator. First, I recommend a conference call with your client and the 401(k) provider to check eligibility. The employer can’t release the funds unless your client is terminated or separated from service. I’ve often seen cases where the employer doesn’t notify the plan provider, and my client is still flagged as an active employee in the system. So, save yourself some time and make sure your client is cleared to move the money and that there are no unexpected penalties, fees or restrictions.
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Request rollover documents from plan administrator. Next, I suggest that you request the rollover forms and confirm what is needed for the new provider. While you are on the phone with the old provider, checking to make sure you are free to move the money, you can also use this time to ask for the required paperwork. In most instances, you will need to submit documentation to start the rollover process so you’ll want to tell them that you are assisting your client and intend to roll the money over and are requesting any necessary forms that need to be completed. By following this process, you will also help your client avoid the 20 percent mandatory federal tax withholding that most plans require if the funds are not rolled over directly.
Understand new account requirements. Further, you’ll want to check with the new account provider to see what they require in order to accept the rollover. In some cases, you may be required to open up an account first before submitting a rollover form. In other cases, the account creation and subsequent rollover may all be part of the same form or process. Either way, your client is counting on you to know what is required and how to get it done. Make sure you have all of the appropriate information from the previous provider first and then complete and submit the forms.