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Roll Over And Play Dead To The IRS

Suppose you’re getting ready to retire at your current job. At long last, you’ll be entitled to the funds you have been scrimping to save in your 401(k) or other employer plan all these years. But the big payoff on retirement day can come with a punch: A hefty income tax bill at rates now reaching as high as 39.6% on the federal level plus any state and local income taxes you may owe. A distribution also might trigger the new 3.8% Medicare surtax that applies to some high-income investors.

What’s a soon-to-be retiree to do? If you require all of the cash right away, you’ll have to take your lumps. However, if you don’t need the money, or at least you can do without much of it, the tax-smart approach is to roll over the funds into an IRA.

A “rollover” is pretty much what it sounds like. You simply take as much cash as you like from the 401(k) and deposit it in an IRA in your name. As long as the rollover is completed within 60 days of your retirement, the amount transferred is completely tax-free. Then you can withdraw the money as desired—it’s taxable at ordinary income rates in each year that you take a distribution—although you must begin minimum distributions no later than the year after the year in which you turn age 70½. In the meantime, the funds in the IRA have the opportunity to continue to grow and compound on a tax-deferred basis.

You can use the funds however you like during the 60-day window. That might be useful, for example, if you’re downsizing to a smaller retirement home and you need cash for a down payment before the sale on your old place closes. Just be sure to deposit the amount of your withdrawal in the IRA before the deadline. But any distribution that actually makes it into your hands is subject to automatic 20% income tax withholding, money you likely can recoup from the IRS when you file your return for the year of the rollover.

To avoid those complications, you could opt for a trustee-to-trustee rollover. In such transactions, the money goes directly from the 401(k) provider to the IRA custodian. Because you never have the funds, a trustee-to-trustee rollover is exempt from income tax withholding, though you still have to report the transfer on your tax return.

Furthermore, once the funds are ensconced safely in an IRA, don’t think that they’re locked in there forever. Under a similar set of rules, you can arrange to transfer the funds tax-free to a different IRA if you like. The same 60-day deadline applies to an IRA-to-IRA rollover.

What about rolling over funds from a 401(k) to a Roth IRA? That will be treated as a taxable distribution. The future benefits available with a Roth--qualified distributions are 100% tax-free after five years--may be worth it, but you’ll have to pay a current tax price.