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Financial Planning > Tax Planning

The Estate Plan: IRA Rollovers

By Calvin Goetz

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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.

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.

Check your work. These forms may require a lot of information, so you’ll want to read them very carefully and make sure you fill them out correctly. If your client’s rollover form from a previous carrier asks what type of distribution this is, you want to be sure to choose a Direct Rollover. This ensures that the funds are made payable to and go directly into their new IRA account with you. This often requires information such as how to make out the check or where to send the money.

Execute the rollover. Now, it’s time to submit the forms, and most plans will require an original signature to initiate the rollover process. However, be sure to check with the plan administrator, as each has their own set of rules and every plan is structured in its own unique way. In many cases, your client will receive a check made payable to the new IRA custodian for the full amount of the rollover in the mail. It is then up to the client to get the check to you and make the deposit into the new account. Make sure the check is made out properly, and submit it for deposit with any required deposit forms.

Prepare for distribution. Now fast forward to the third financial phase, which occurs in retirement, the distribution phase. Once your client starts taking distributions from the IRA you established, you’ll need to be aware of the most common distribution mistakes. The following tips apply when your clients reach age 70-and-a-half and you need to help them avoid a 50 percent tax on Required Minimum Distributions (RMDs) that are not taken by the Required Beginning Date (RBD).

The RBD is when your clients must start withdrawing from their IRA. This can initially be confusing because the rules for the first RMD will vary slightly in the first year compared to all future years once your client is over 70-and-a-half. The RBD is April 1st of the year following the year your client has turned 70-and-a-half. If your client turned 70-and-a-half in 2011, the RBD will be April 1st of 2012. Remember, if your client missed an RMD, the penalty is 50 percent of the required amount that was not taken.

“Once your client starts taking distributions from the IRA you established, you’ll need to be aware of the most common distribution mistakes.”

 Here’s an example:

If John turns age 70-and-a-half in 2011, his RBD will be April 1st of 2012, and his first RMD must be taken by April 1, 2012. However, John’s second RMD for tax year 2012 must be taken before the end of 2012 and must follow this schedule from now on. This results in two taxable withdrawals in one tax year, which can cause your client to pay higher taxes for that year. I recommend processing the first RMD withdrawal before the end of the year when the client turns 70-and-a-half to avoid this double RMD tax trap.

Be careful, as many advisors I’ve met with are unsure of these rules and believe that RMDs can be taken out by April 1 of the following year, every year, and not just the first year. I recommend setting up a systematic Required Minimum Distribution to avoid any confusion and potentially expensive tax penalty in future years.

With more than 76 million boomers transitioning into retirement, and the trillions of dollars invested in their 401(k)s that will need to be rolled over, you must be equipped with this information to help your clients make important rollover decisions. By following the steps outlined here, you will be able to help them avoid the potentially expensive tax traps that could happen during retirement.

Calvin Goetz is partner and co-founder of Strategy Financial Group, Phoenix

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