5 essential tax questions about IRAs, rollovers and retirement plans

A direct rollover is defined as an eligible rollover distribution (see above) that is paid directly to an eligible retirement plan for the benefit of the distributee. A direct rollover may be accomplished by any reasonable means of direct payment, including the use of a wire transfer or a check that is negotiable only by the trustee of the eligible retirement plan. Giving the check to the distributee for delivery to the eligible retirement plan is considered reasonable provided that the check is made payable to the trustee of the eligible retirement plan for the benefit of the distributee. Certain amounts may be rolled over only in the form of a trustee-to-trustee transfer. Plans are not required to accept rollovers, direct or otherwise.

If a participant’s total distribution is expected to be less than $200, the participant need not be offered the option of a direct rollover. While a participant must be permitted to elect a direct rollover of only a portion of the distribution, a plan administrator may require that this direct rollover portion equal at least $500. In the case of Section 403(b) tax sheltered annuities, the payor of the eligible rollover distribution is treated as the plan administrator.

A plan administrator is not required to permit a participant to make a direct rollover of only a portion of the distribution if the full amount of the distribution totals less than $500. A plan administrator may permit a participant to divide the distribution into separate distributions to be paid to two or more eligible retirement plans in direct rollovers but is not required to do so. (see above)

If an eligible rollover distribution from a qualified retirement plan, tax sheltered annuity, or eligible governmental 457 plan is not handled by means of a direct rollover, the distribution will be subject to a mandatory income tax withholding rate of 20 percent.

Plans subject to the direct rollover rules are required to provide that a cash-out distribution in excess of $1,000 and less than $5,000 will automatically be transferred to an individual retirement plan unless the distributee affirmatively elects to have it transferred to another eligible retirement plan or elects to receive it directly.

4. If a rollover is not made through a direct rollover, must income tax be withheld from the distribution?

Distributions from qualified retirement plans, tax sheltered annuities, and eligible Section 457 governmental plans are subject to a mandatory income tax withholding rate of 20 percent unless the transfer is handled by means of a direct rollover. An employee receiving a distribution may not elect out of the withholding requirement. Distributions from traditional IRAs are not subject to mandatory 20 percent withholding.

If a participant receives an eligible rollover distribution that is subject to the 20 percent withholding rate, the 20 percent withheld will be includable in income even if the participant rolls over the remaining 80 percent of the distribution within the 60-day period. Because the amount withheld is considered to be an amount distributed under those sections, the participant may add an amount equal to the 20 percent withheld to the 80 percent he or she has received, resulting in a rollover of the full distribution amount.

Where a distributee elects to transfer a portion of the distribution by a direct rollover and receive the remainder, the 20 percent withholding requirement applies only to the portion of the distribution that the distributee actually receives. It does not apply to the portion of the distribution that is transferred directly to another eligible retirement plan.

5. May an individual who is not a participant in a qualified plan rollover amounts received from the plan by reason of a divorce or separation agreement?

Yes, if the agreement is a qualified domestic relations order (“QDRO”) and certain requirements are met.

A QDRO is a decree or judgment under state domestic relations law that recognizes or creates the right of a spouse or child to receive, or to have set aside, a portion of a participant’s interest in a qualified plan, 403(b) plan, or eligible Section 457 governmental plan.

If an alternate payee who is the spouse or former spouse of the participant receives a distribution by reason of a QDRO, the rollover rules apply to the alternate payee as if the alternate payee were the participant. Thus, the alternate payee can avoid the requirement of including the distribution in income to the extent any portion of an eligible rollover distribution is directly rolled over or rolled over to an eligible retirement plan within 60 days.

A qualified retirement plan may be an eligible retirement plan for an alternate payee who is a spouse or former spouse of the participant and who receives the distribution by reason of a QDRO. This kind of rollover must be handled through a direct rollover to avoid a mandatory income tax withholding rate of 20 percent. There are separate rules applicable to surviving spouses.

QDRO rules do not apply to IRAs. An IRA, however, can be transferred tax-free in connection with a divorce if the correct procedure is followed. In such cases, the transfer of an individual’s interest in an IRA or an individual retirement annuity to a spouse or former spouse under a divorce or separation instrument is not considered a taxable transfer made by the individual, and such interest at the time of the transfer is treated as the spouse’s IRA and not such individual’s IRA. Thereafter the account or annuity will be treated as maintained for the benefit of the spouse.