The information in this article is up to date through tax year 2019 (taxes filed in 2020).
When you decide to leave your current job – whether it’s for retirement or for another employer – you may choose to withdraw your money from your company retirement plan. Depending on your circumstances, this could result in early withdrawal penalties and fees.
Rather than losing all the tax benefits of your retirement plan, you might consider moving your funds into an Individual Retirement Account (IRA) instead. Contributions to an IRA are allowed to grow tax-free or tax-deferred until you reach retirement. Here are some important things to know about maintaining your tax benefits when shifting your money between accounts.
If you withdraw your investment from your company retirement plan early (that is, before age 59 ½), the transaction will be treated like a distribution. Not only will you owe tax on the amount you take out, you would also be charged a penalty for early withdrawal. But, by rolling those funds into an IRA, you can avoid those liabilities and your money can continue to grow tax-deferred until you choose to withdraw it.
There are a couple of ways to open a rollover IRA. The first is by direct transfer. With this method, your employer sends a check payable to the financial institution that manages your IRA. Because you never actually take possession of the money, it is not treated like a distribution for tax purposes.
Alternatively, you could choose an indirect rollover. In this case, your employer will send a check to you, and you will have 60 days to deposit the amount in your rollover IRA. After 60 days, you will become liable for tax withholdings and withdrawal penalties.
You can roll funds over from one IRA to another IRA (or to the same IRA) one time within a 12-month period. IRA rollovers are still reported on your tax return even though they are non-taxable. You should receive two tax forms about the transaction. Your distribution will be reported on Form 1099-R, and your rollover contribution will be reported on Form 5498.
An IRA transfer occurs when you move funds from one financial institution directly to another, generally between accounts of the same type. For example, if you move money from one traditional IRA to another, that transaction would be considered an IRA transfer. As long as you don’t receive a distribution check in the process, then the transfer would not be taxed.
With a Traditional IRA, your contributions are tax-deferred until you make a withdrawal in retirement. But if you have a Roth IRA, your contributions are taxed and any withdrawals you make after you stop working are tax-free. So, if you expect to earn significantly less income this year, you might want to convert your Traditional IRA to a Roth and pay tax at your current lower rate. In that case, the converted amount is treated like a distribution from the traditional IRA, and the payout goes into the new Roth account.
On the other hand, if the distribution is large enough, it could put you in a higher tax bracket for the tax year you make the conversion. This could result in a bigger federal and/or state income tax bill for this year. It’s not always easy or possible to predict whether a conversion will increase your liability or not. To prevent paying more taxes as a result of a conversion, you used to be able to undo the transaction using a “recharacterization.” However, the Tax Cuts and Jobs Act permanently prohibited recharacterizations beginning in tax year 2018.