This is intended to discourage people from invading retirement plans early. And, it generally works.

However, there are occasional cases in which a person simply must begin taking funds from their IRA. There is a way to avoid these penalties. It is known as the SEPP or “Substantially Equal Periodic Payments” plan also identified by the tax code as 72(t). These payments must continue until the person is age 59 1/2 or 5 years, whichever is later. If these payments are modified, all of the prior payments become subject to the penalties. You must be very careful about violating the rules if you embark on this plan.

Here is the story about someone who innocently got stung by “modifying” her payments.

In a recent IRS Private Letter Ruling the rigidity of the rules under IRC § 72(t) by which substantially equal periodic payments are exempt from the 10% early withdrawal tax is illustrated. An individual’s non-taxable transfer of a portion of her individual retirement account to another IRA constituted a prohibited “modification” of the payments, which the IRS ruled could not be corrected by reversing the transfer. The error resulted in the distributions she had taken over the prior seven years all being subject to the 10% early withdrawal tax and interest.¹

Transfer of Only a Portion of the IRA Caused a Modification

In 2008, an individual taxpayer submitted a request to the IRS for a private letter ruling (PLR) after learning that her non-taxable transfer earlier that year of a part of her IRA resulted in a prohibited “modification” of the “substantially equal periodic payments” plan she had been taking from that IRA since 2002. The taxpayer had completed the transfer on the advice of a financial advisor who suggested she invest a portion of the IRA in certificates of deposit, which were not available at the current financial institution, but which were available for IRAs at another institution. After opening another IRA at the other institution, the taxpayer transferred a part of her original IRA. Later the same year, the taxpayer consulted with representatives of a third financial institution about the possible transfer of the remaining IRA assets and was informed that the prior transfer constituted a “modification” of her series of substantially equal periodic payments. In later speaking with her financial advisor she was told that the transfer would cause the imposition of the 10% early withdrawal tax, plus interest, on all amounts that had been withdrawn from the IRA since 2002.

Early Distribution Penalty Applies Retroactively

The taxpayer was age 56, and had begun taking substantially equal periodic payments from the IRA six years earlier at age 50, in 2002. IRC 72(t)(1) imposes a 10% tax on early distributions from qualified plans and IRAs. However, the tax is not imposed if the distributions are part of a series of “substantially equal periodic payments” that are made at least annually over the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and beneficiary. But, if the payments are modified (other than by reason of death or disability) before the individual reaches age 59-1/2, or after the individual reaches age 59-1/2 but before the close of the 5-year period beginning with the first payment, then the taxpayer is obligated to pay the 10% early withdrawal tax that would have been imposed on the earlier payments, plus interest.

“Substantially equal periodic payments” are calculated by using the account balance as of the first valuation date selected. Therefore, as the IRS explained in the letter ruling, a modification occurs if there is any (1) addition to the account balance other than gains or losses, (2) nontaxable transfer of a portion of the account balance to another retirement plan or IRA, or (3) rollover of the amount received so that it results in the distribution not being taxable.

Error Cannot Be Corrected by Reversing the Transfer

As a result, despite the fact that the transfer was made on the basis of erroneous advice from her financial advisor, and the taxpayer had proposed to correct the error by transferring the amount back to the original IRA, the IRS ruled that a “modification” had occurred and could not be corrected by undoing the transfer. Since the modification occurred in 2008, before the taxpayer reached age 59-1/2, she was obligated for that year to pay an additional 10 percent early distribution tax on the distributions she had taken from the IRA since 2002, plus interest.

It seems sort of unfair to the taxpayer since it was the result of incorrect professional advice and since she offered to restore the funds to their original position. This does underscore the importance of good advice before taking action in the more esoteric areas of practice. The rules really are quite clear, but not too many people take action under the SEPP provisions of 72(t) and as a consequence even many advisors are not clear on the rules.
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¹.PLR 200925044 (March 23, 2009)

For those who value an Advisor for their ability to deliver positive investment returns year after year, irrespective of the state of markets, you are probably very disappointed this year.

And for those who look for an Advisor to have expertise as a consistently accurate forecaster, you probably have serious doubts by now.

But I would like to expand the expectations of consumers of financial advice beyond just market dependant performance. The value of a good Advisor is not dependent on the state of markets. Indeed, their value can be even more evident when markets are down and fear is running high.

The best of these Advisors play multiple and nuanced roles with their clients, depending on the stage of the relationship, and these clients are amply rewarded for the manifest skills their Advisors bring to the table.

While some may quibble over the exact characterization, broadly these functions break down to seven important roles that evolve over time:

1. The expert: Now, more than ever, investors need Advisors who can provide client-centered expertise in assessing the state of their finances and developing risk-aware strategies to help you meet your goals.
2. The independent voice: The global financial turmoil of the past two years has demonstrated the value of an independent and objective voice in a world full of product pushers and salespeople. A real independent Advisor is not a product pusher or salesperson.
3. The listener: The emotions triggered by financial upheaval are real. A good Advisor will listen to client’s fears, ferret out the issues driving those feelings and provide practical long-term solutions.
4. The teacher: Getting beyond the fear-and-flight phase often is a matter of teaching about risk and return, the power of diversification, the importance of asset allocation and the virtue of discipline. Done generically, this is the primary goal of Capital Markets U.com magazine.
5. The architect: Once these lessons are understood, the Advisor can become an architect, helping you to build a long-term wealth management strategy that caters to your own risk appetites and lifetime goals. This goes far beyond stock picking expertise or market timing expertise (both of which Capital Markets U.com considers dubious at best).
6. The coach: Even when the strategy is in place, doubts and fears will inevitably arise in the your mind. An excellent Advisor at this point becomes a coach, reinforcing first principles and keeping you on track.
7. The guardian: Beyond these early experiences is a long-term role for the excellent Advisor as a kind of lighthouse keeper or guardian, scanning the horizon for issues that may affect you and keeping you informed. This role is only possible if you have had a relationship with your Advisor for some time. An Advisor filling this role has to know you and your family very well.

These are the seven faces of advice and, when properly applied, become testimony to the fact that the value of a good financial Advisor extends well beyond the writing of a simple financial plan or simply being limited to investment management.

You may first seek out an Advisor purely because of their role as an expert. But once you are satisfied with their expertise, you may find their main value may be their role as an independent voice.

Knowing your expert Advisor is truly independent — and not a product salesperson — leads to your ability to trust your Advisor as a listener or sounding board, as someone to whom you can unburden your greatest fears.

Once your relationship with your Advisor has developed, the listener can become the teacher, the architect, the coach and ultimately the guardian. These are all extremely valuable roles in their own right and none of these are dependent on the investment markets.

However you characterize these various roles, a good financial Advisor ultimately is defined by the patient building of a long-term relationship founded on the values of trust and independence.

I hope this has helped to expand your expectations of your Advisor. And, if you didn’t realize all this was possible in one Advisor, you can now begin to look for a truly excellent Advisor.

Let’s say you now age 60 and don’t plan to retire from your job for another five years, and your 401(k) plan is very expensive and has less poor investment options. You can roll your $1 million 401(k)(or less – don’t we all wish our 401(k)’s were worth at least $1 million?), into an individual retirement account (IRA), using a little-known maneuver known as an “in-service” non-hardship distribution.

Employers and 401(k) plan administrators don’t promote this fact (it’s not in the financial best interest of some administrators and brokers), but most workers 59 1/2 and older, and even some younger ones, can roll over 401(k) funds while they’re still working and contributing to the plan. This option isn’t right for every participant. But in most cases it can provide better investment choices, a better beneficiary choice options or even a chance (new in 2008) to transfer 401(k) dollars directly into a Roth IRA.

The law allows workers to empty their 401(k) accounts once they hit 59 1/2 without the Federal 10% penalty and the State penalty. They can roll all the money directly into an IRA without paying tax now. Or they can take cash out, pay any ordinary income taxes due and spend what’s left (usually not a good idea). The same goes for plan participants in government and not-for-profit savings plans similar to 401(k)s.

The law permits these in-service withdrawals, but employers’ plans don’t have to permit it. Still, 70% of companies–and 89% of those with 5,000 or more employees–allow these in-service withdrawals, the Profit Sharing/401k Council of America found in a 2006 survey of 1,000 firms. So do some public sector employers; the federal government, for example, allows older workers to withdraw funds, but only once.

As for pre-59 and a half year old folks, the law permits them to get in-service distributions of money rolled over from previous 401(k)s; of employer (but not employee) pretax contributions; of employee after-tax contributions; and of account earnings. Here companies are less accommodating–only 16% allow this option, the 2006 survey found. Note that if a younger worker spends the cash, instead of rolling it over, he’ll owe an extra 10% Federal penalty plus any State penalty (2.5% in California for example) on the taxable amount, just as he would if he got a “hardship” distribution from his 401(k) or took a loan from his 401(k) and switched jobs without repaying the loan.

One obvious reason to consider an in-service rollover is to escape a bum plan that has expensive or mediocre funds. Some small plans have annual fees on domestic equity mutual funds that top 2% a year. Outrageous. If you’re stuck in one of those, you can chop your costs by rolling your 401(k) money into an IRA at a no-load fund company such as Vanguard, Fidelity or T. Rowe Price, or if you work with an Advisor, pick one who works with Dimensional Funds (DFA). They have some meaningful structural advantages to the other low cost funds.

Another strategy: roll over part of your money. If you have some good choices in your 401(k) but not enough, roll over part of your funds to an IRA so you could invest in better quality funds like those from Dimensional Fund Advisors, including small-capitalization and value funds if there are no comparable offerings in your company plan (which there probably aren’t). It is a good bet that with better structured DFA funds and professional asset allocation and other advice, you’ll come out ahead.

Not surprisingly, outside financial planners and Investment Advisors push rollovers, since they can frequently do a better job and, not surprisingly, it gives them more money to manage and collect fees for. In other words, it is a legitimate growth opportunity for Fee-Only Financial Planners and Investment Advisors. Fifty-year-olds, as they near retirement and their 401(k) balances grow, want and are willing to pay for professional help. You can find a Fee-Only Advisor in your area at the National Association of Personal Financial Advisors (NAPFA).

There are a few other reasons to consider an in-service IRA Rollover. One is a provision, new this year, that allows you to roll 401(k) money directly into a Roth IRA, where future earnings will be tax free. If your plan administrator is ready to cut a separate check with just your after-tax contributions, it appears (although the Internal Revenue Service hasn’t issued rules on this) that you can roll that money directly into a Roth IRA and pay no taxes on the conversion. For now Roth rollovers are allowed only for those with family incomes of $100,000 or less. That income restriction is due to end in 2010.

Another reason to do an in-service rollover comes up when coordinating estate planning with retirement planning, if you’re leaving retirement money to someone other than your spouse, like your kids or grandkids. A spouse who inherits either a 401(k) or an IRA can roll it into his or her own IRA with all the same flexibility that an IRA offers its original owner. Kids, grandkids or other non-spousal heirs who inherit an IRA can’t roll it over into their own IRA, but they can keep the money in an “inherited” IRA, potentially stretching out withdrawals and tax deferral for decades based on their life expectancy. Under a 2006 law change, children and other “non-spousal” heirs can roll 401(k)s into inherited IRAs–but only if the employer permits it, which not all do. If your employer doesn’t allow it, it might be a good topic for discussion with your HR Department. If your employer is unwilling to cooperate, get the money out now and put it into an IRA that won’t have any employer getting in the way of your estate planning. (A non-spousal heir can’t convert an inherited IRA to a Roth IRA.)

Before you rush to do an IRA Rollover, consider some advantages to your 401(k). In a good plan the fees, particularly for index funds and passively managed asset class funds like those at Dimensional Fund Advisors (DFA), can be extremely low. If you retire early, you can make penalty-free withdrawals from a 401(k) at age 55; with an IRA, you generally have to wait until you’re 59 and a half unless you commit to a 72(t) withdrawal plan (periodic payments for 5 years or age 59 1/2 whichever comes later). When other options aren’t available, you can take a loan (of up to $50,000) from your 401(k) but not your IRA.

Plus, if you hold your company’s stock in your 401(k), you may be eligible for a tax break at retirement called a NUA or Net Unrealized Appreciation strategy. If you transfer the company stock to a taxable account, you’ll pay ordinary income tax (at rates of up to 35%) only on what the stock was worth at the time it was put into your 401(k). Any further capital appreciation won’t be taxed until you sell the stock and then it will be at the long-term capital gains rate–which for now anyway tops out at 15%. There are some intricate rules here that determine whether you’re eligible for this break. So if you’ve got your employer’s stock in your 401(k), check with your plan administrator and your tax adviser. This may be a time for doing a partial in-service non-hardship withdrawal leaving the company stock in the plan until retirement time.

Spouses who who have been widowed and participate in a 403(b), government 457 or qualified plan may roll over distributions from their deceased spouse’s plan into their own plan, provided the accepting plan includes a rollover provision. And with IRS approval, the 60-day period in which to make a rollover can be extended if not doing so would be against “equity or good conscience,” as stated by the law. Examples of instances when the waiver of the 60-day period will be considered appropriate include matters outside the control of the individual, such as a natural disaster, hospitalization or a failure of a financial institution to process the rollover in a timely manner (and this does happen, just ask me).

Below is a chart indicating what can be rolled over into what. 

The construction sector (left) accounted for the highest number of job cuts in 2008. Linens ‘n Things was among several retailers to close stores last year. 
 

The unemployment rate in California soared to 9.3 percent last month – its highest point in 15 years – as construction firms, hotels, restaurants, casinos and amusement parks laid off workers in response to the widening recession.

Statewide, 78,200 workers lost their jobs in December, bringing the year-over-year job losses to 257,400, according to data released yesterday by the state Employment Development Department.

The jobless rate represented a major jump from 8.3 percent in November and 5.9 percent in December 2007. The national unemployment rate was 7.2 percent last month.

With job losses projected to continue into the near future, many economists, employment experts and labor leaders say it’s likely California’s jobless rate will hit double digits later this year, topping the recession of the early 1990s.

“We’re facing a code-red economic crisis,” said Art Pulaski, executive secretary-treasurer of the California Labor Federation. “Skyrocketing joblessness is causing workers and their families to fall further into a deep, dark hole that is helping to fuel a vicious downward spiral for our state’s economy.”

Stephen Levy, director of the Center for the Continuing Study of the California Economy in Palo Alto, said that employment “really fell off a cliff” during the last two months of 2008 and that it will take at least nine months for government stimulus programs to have a noticeable effect on hiring.

Levy expects that the jobless rate “will certainly go over 10 percent this year, and it’s hard to know where it will end up.”

Economists say the latest figures show that the crisis that started when the bubble in housing prices burst two years ago has spread throughout the economy.

For much of the past two years, job losses were concentrated in construction firms, real estate and mortgage brokerages, and banks. But now, as debt-laden homeowners and other consumers cut back on spending, job losses have seeped into shopping malls, restaurants and factories.

Of the 11 broad industrial categories that the state uses to define jobs, only one – health and education services – added jobs last month. Eight industries ended 2008 with fewer workers than when the year started, including trade, transportation and utilities; information services; manufacturing; and leisure and hospitality.

“This has really morphed into a consumer-driven recession, which means that companies are paring production and stores are closing and laying off staff,” Levy said. “That’s a very vicious cycle.”

Gov. Arnold Schwarzenegger cited the growing unemployment rate as evidence that the state needs “aggressive economic stimulus” – including revenue increases, job creation programs and government streamlining.

San Diego County’s net job loss in December was 1,100, pushing the unemployment rate to 7.4 percent and the year-over-year job loss to 18,400.

It was the worst month for unemployment in the county since August 1994, when local defense factories were shutting down after the end of the Cold War. In comparison, the county’s jobless rate was 6.9 percent in November and 5.0 percent in December 2007.

The monthly job losses – including 1,100 cutbacks in leisure and hospitality and 900 in construction – were partly offset by seasonal hiring in retail and wholesale.

But seasonal hiring levels were much lower than usual. Retailers added only 300 jobs in December, compared with 2,600 a year before.

“This is the first time there’s been no real bump in retail jobs,” said Kelly Cunningham, economist at the San Diego Institute for Policy Research. “Even in the recession of the 1990s, we saw big bumps in employment in December as retailers hired workers. But it really shouldn’t be too surprising, considering how much consumers have been cutting back their spending.”

Over the entire year, retailers in San Diego County shed 8,400 jobs. Except for grocery stores, which added 400 jobs, every retail category was down, led by auto showrooms, department stores, building suppliers, pharmacies and clothing boutiques.

“We haven’t seen the worst of it,” Cunningham said. “Some retailers – like Circuit City – were just holding on through the holidays to see how good sales would be. But a lot of retailers are now going to start laying off workers and shutting down stores.”

Beyond retail, job losses in the county during 2008 were concentrated mostly in construction, which lost 5,300 jobs; professional services, 1,900; manufacturers, 1,600; real estate workers, 1,300; and banking and finance, 1,300.

The bright spots for employment during the year were health care and social assistance, which added 1,600 jobs; education, 1,500; and the military, 600. Despite the spike in unemployment, San Diego continues to perform better than many other regions of California. The unemployment rate has hit 9.5 percent in Los Angeles County and has topped 10 percent in Riverside and San Bernardino counties as well as some Central Valley cities.

Economists expect San Diego to continue to outperform the state, but they also think that there will be more job losses as the year progresses.

“I don’t think this threatens San Diego’s long-term economy, but it will be a very difficult 2009,” Levy said.
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Dean Calbreath: (619) 293-1891; dean.calbreath@uniontrib.com

So, here goes:

Principle #1. The Stock Market is Efficient. If you get this, you will protect yourself from all kinds of scams and flim-flam artists. What does it mean? In simple terms, it means that no one, no money manager, no market guru, no hedge fund manager, no one, can, over time, beat the stock market returns . . . . period! I don’t care what TV show or radio show they are on. I know I will get all kinds of grief over that statement, but the academic studies (not Wall Street marketing departments) are on my side – or actually, I am on their side. Every statistically significant study I know of, and I have read a lot, substantiates this position.

So, what does this mean for how you should invest your IRA money? It means, do not use “active managers.” Active managers are those money managers who believe they are smarter and better than the markets and all the rest of the professional investors and they can pick the right stocks and time the markets correctly so that they can produce superior returns over the markets. Don’t buy into this hype and you will stay away from the ego maniacs, scam artists, flim-flam artists and the misguided and well meaning investment advisors who have drank the cool-aid of active management. Instead, if you are a do-it-yourselfer, stick to broadly diversified, low cost Index Funds, broadly diversified Exchange Traded Funds (ETFs). Use an inexpensive discount brokerage firm to hold your account.

If you are not a do-it-yourselfer, hire a fee-only registered Investment Advisor who uses passive low cost asset class funds only – like funds by Dimensional Fund Advisors (DFA) or Vanguard Funds. Usually, the total cost of investing with these kinds of advisors will be less expensive than just the internal cost of active funds, so paying a fee-only advisor will generally still cost less than using actively managed funds before you pay the advisor. This is definitely the case with the firm I work with.

All active managers introduce more risk into your portfolio than passively managed asset class funds – it is called non-systematic risk. You don’t get compensated for non-systematic risk, so why take it?

All active managers add more costs to investing than passive investing. These costs are not revealed in reports or the prospectus. You can estimate the difference by looking at the “turnover rate” of the portfolio: the higher the turnover, the higher the cost. With broadly diversified stock funds, the turnover rate should usually be less than 10%.

Active managers add costs and risks and generally underperform their passive counterparts, so why use an active manager? It doesn’t pay and, after all, isn’t that what you want your IRA investments to do. . . . pay?

For those who want to do more research on this issue of the stock market being efficient, do a Google search on Efficient Market Hypothesis and Professor Eugene Fama of the University of Chicago Graduate School of Business.

Principle #2. Diversification is Key The way to consistently win is to hold very broadly diversified, global, low cost, asset class mutual funds. Diversification reduces uncertainty. If you hold a mutual fund of US securities with about 3500 stocks in it and one of them happens to be a Bear Stearns or Lehman Brothers, it will hardly make a blip in your portfolio as it goes out of existence. Don’t be caught with concentrated position mutual funds or with individual securities. You will be carrying too much risk that you can diversify your way out of.

Stock pickers and market timers will tell you just the opposite. They will say you should pick the particular asset classes or stock industry groups that will outperform in the next time period and either buy funds specializing in those groups or buy individual stocks in those groups because “it is a stock picker’s market.” One significant problem with that approach is not only that you will need to know  which stocks of funds to buy in advance of their performance, but you will also have to know when their “time” in the sun is over and dump them before you give back your predicted gains. So now, you have to be right twice. When you look back at Principle #1, it becomes obvious that “concentrated positions” that are determined by stock pickers or market timers are foolish for a long term investor. Owning a concentrated portfolio does hold the possibility of outperforming the market, but it does so at a risk level generally not understood nor appreciated. Most who try concentrated portfolios fail.

Principle #3. Risk and Return are Related. Exposure to meaningful risk factors in a diversified portfolio determines expected return. Over the long haul, stocks outperform bonds but not always; over the long haul small stocks outperform large stocks, but not always; over the long haul value stocks outperform growth stocks, but not always. Each of these outperformers has a greater volatility risk and a greater expected return.

The table below shows the Annualized Compound Returns as well as the Annual Average Returns for both domestic and non-US stocks for periods as long as we have reliable data. This data supports my contention that small and value stocks outperform over time and that it applies to the whole world of stock investing.

For a larger image, click the image twice.

Principle #4.Portfolio Structure Determines Performance. Asset allocation along size, value, and market exposure dimensions primarily determines the results of a broadly diversified portfolio. In other words, to increase the expected return of your portfolio, own low cost, globally diversified asset class mutual funds that are over weighted to smaller and more value oriented stocks. If an all stock fund portfolio is too volatile for you, add some short term high quality bond funds to damper the volatility.

Following academically sound investment principles will allow you to win the losers game. Don’t give in to the Wall Street marketing gurus who have proven their ability to separate you from your money, quickly and permanently.

What is an IRA Rollover?
An IRA Rollover is a tax-free transfer of funds from a tax-deferred plan, such as a 401(k) plan, Thrift Savings Plan, Defined Benefit Plan, 403(b) Plan, etc., to a traditional IRA. An IRA Rollover can be done when an employee changes jobs, is laid off or retires and is entitled to a distribution from the old employer’s 401(k) plan or other Qualified Retirement Plan. By doing an IRA Rollover, the funds can be transferred tax-free to the employee’s own IRA. This means the funds can continue to grow on a tax-deferred basis inside the IRA. It also means that the funds are under the complete control of the employee with respect to investment decisions and future distributions.

The term “IRA Rollover” can also be applied to a transfer of funds from one IRA to another IRA. This too can be done on tax-free basis under a different set of rules that apply to IRA-to-IRA rollovers. Those rules are covered separately.
 
IRA Rollovers from Employer-Sponsored Plans

When is an IRA Rollover permitted for distributions from an employer-sponsored plan?
An IRA Rollover is permitted for any “eligible rollover distribution” from an employer-sponsored plan. This includes distributions from 401(k) plans when an employee changes jobs or retires, but also includes eligible rollover distributions from other employer-sponsored plans, such a qualified pension and profit-sharing plans, defined benefit plans, 403(a) annuity plans, 403(b) annuity contracts and governmental 457 plans.

What is an “eligible rollover distribution” from an employer-sponsored plan?
Any distribution, whether all or less than all of the employee’s account, is an eligible rollover distribution, except for the following:

• Any distribution which is part of a series of substantially equal periodic payments (SEPP);
• Any required minimum distributions (RMD);
• Any distribution which is made upon hardship of the employee;
• Certain returns of elective 401(k) contributions, corrective distributions, loans treated as distributions, and similar items.

When can I take a distribution from my 401(k) plan or other employer-sponsored plan?
Distributions from a 401(k) or other employer-sponsored plans are governed by IRS rules as well as the terms of the plan. In general, plan distributions require a triggering event, such as:

• Termination of employment
• Attainment of the plan’s normal retirement age
• Death

Check with your plan administrator to be sure that you are entitled to a distribution under IRS rules and the terms of the plan and to determine what procedures are used to request such a distribution.

How are IRA Rollovers from employer-sponsored plans done?
The employee usually has a choice of two methods to accomplish the IRA Rollover – the direct rollover or the indirect rollover.

Direct Rollover

In a direct rollover, which is also sometimes called a “trustee-to-trustee transfer,” the eligible rollover distribution that is transferred directly by the employer-sponsored plan to the employee’s IRA. The funds are never actually transferred to the employee individually.

Indirect Rollover

Under the indirect rollover method, the employer-sponsored plan writes a distribution check to you, you then deposit the check in your own account. You then have 60 days to transfer all or a portion of the amount received in the distribution to an IRA. The distribution is not taxable to you if you do the transfer within 60 days.

What are the advantages and disadvantages of the direct rollover vs. the indirect rollover for distributions from an employer-sponsored plan?
An important advantage of the direct rollover method is that it allows you to avoid the IRS mandatory withholding rules. Under those rules, when a distribution is made by the plan to you, even if you intend to roll over the distribution into an IRA within 60 days, it is subject to a mandatory 20% income tax withholding rule that applies to all qualified plan distributions.

This means that the actual distribution check will represent only 80% of the amount of the distribution that is eligible to be rolled over. Therefore, in order to satisfy the 60-day rule for the entire distribution, you would need to “make up” the withheld 20% out of other funds (if available) to complete the rollover. Otherwise, the 20% withheld would be treated as a taxable distribution that was not rolled over on time resulting in only 80% of the distribution being tax deferred.

There may be practical advantages to the direct rollover as well. The transfer of funds can be handled directly by the two institutions. This eliminates concerns or mix-ups regarding calculating the 60-day period and making sure you comply.

If you have a short-term need for funds, the indirect rollover does give you use of the funds for up to 60 days, which is not the case with the direct rollover. In most cases, that is not a significant consideration. And does open you to the possibility of not being able to deposit the fund into your IRA in time.

Are employer-sponsored plans required to give employees the option to do direct rollovers?
Yes, as long as the direct rollover is to an IRA. Every plan, as a condition of qualification, must provide that a recipient of an eligible rollover distribution may elect to have the distribution transferred directly to an IRA. Distributions of less than $200 are excluded from the direct rollover requirement. (See below direct rollovers from other eligible retirement plans.)

What procedures are used to elect a direct rollover?
The plan administrator can use any reasonable procedure for you to elect a direct rollover. That is why it is important for you to check with your plan administrator about the IRA Rollover process.

How is the direct rollover done?
A direct rollover may be done by any reasonable means of direct payment to the IRA chosen by the plan administrator, including:

• A check mailed by the employer-sponsored plan to the IRA custodian or issuer of the IRA annuity, as long as the check is negotiable only by the IRA custodian or annuity issuer;
• A wire transfer, as long as it directed only to the IRA custodian or annuity issuer;
• Hand delivery of a check by you to the IRA custodian or annuity issuer, as long as instructions are given to you to deliver the check to the IRA custodian or annuity issuer and the check is made payable to the IRA custodian or annuity issuer.

Can employer-sponsored plan benefits be rolled over into other types of retirement plans besides IRAs?
Yes, maybe. Eligible rollover distributions can be made to any “eligible retirement plan.” This means, in addition to an IRA, another qualified plan, a 403(a) annuity plan, a 403(b) annuity contract, or certain governmental 457 plans. For example, this rule enables an employee who is switching jobs, who is entitled to a distribution from the prior employer’s 401(k) plan, to roll over his or her plan benefits to the new employer’s plan, whether it is a 401(k) or some other type of employer-sponsored plan.

Although many employer-sponsored plans do accept such rollovers, note that an eligible retirement plan does not have to accept rollover distributions. So any employee who wants to move his or her 401(k) balance from an old employer to the new employer’s plan needs to make sure that the new employer’s plan accepts such rollovers. If it does not, then the employee would still be able to do an IRA Rollover.

Can after-tax amounts in an employer-sponsored plan be part of an IRA Rollover?
Yes, after-tax amounts can always be rolled over from an employer-sponsored plan to an IRA. However, for rollovers to other eligible retirement plans, the only employer-sponsored plans that can accept after-tax amounts are defined contribution plans that agree to separately account for the pre-tax and after-tax portions of the rollover.

IRA Rollovers from IRAs

What are the rules for IRA Rollovers from one IRA to another IRA?
The rules are very similar to those for employer-sponsored plans, but take into account the technical differences between an employer-sponsored plan and an IRA.

Since an IRA owner can take distributions any time from the IRA, subject only to potential premature distribution penalty taxes, there is no requirement that the distribution constitute an eligible retirement distribution before it can be rolled over. Thus, in general, it is easier to do an IRA-to-IRA rollover. However, there are other rules that also need to be satisfied.

Partial distributions from an IRA can be rolled over, but a required distribution under the minimum required distribution rules (RMDs) cannot be rolled over.

In the case of an IRA-to-IRA rollover, how can the rollover be accomplished?
You can do this either as a direct rollover or an indirect rollover, just as a rollover from an employer-sponsored plan. Either method results in a tax-free transfer of the funds from one IRA to another IRA. Since the mandatory withholding rules do not apply to IRA distributions, that is not a factor for choosing one method or the other.

The main difference is that, in the case of an indirect rollover (i.e., a rollover in which the funds are distributed from an IRA to the IRA owner who then has 60 days to transfer them to another IRA), such a rollover is limited, for each IRA owned by the IRA owner, to one such indirect rollover in any one-year period. If an individual owns more than one IRA, a tax-free indirect rollover from one IRA will not prevent another tax-free indirect rollover from a different IRA within that one-year period.

The key point is that the one-rollover-per-year rule does not apply to trustee-to-trustee transfers. The direct rollover thus eliminates a potential technical issue the individual wishes to do a second rollover of those funds within a one-year period.

There are also practical advantages to the trustee-to-trustee transfer, including the practical benefits of moving the funds by wire transfer, if available, as well as avoiding any need to calculate and comply with the 60-day rule.

Obviously, if you have a short-term need for cash, the indirect rollover does give you the use of those funds for up to 60 days, which is not the case with the trustee-to-trustee transfer, but those instances where that is an important consideration are not common.

Can additional funds be added to the Rollover IRA in the future?
Yes. You can either make annual contributions to the IRA under normal IRA contribution rules or can make future IRA Rollovers to the IRA. Old rules that prevented or discouraged commingling of rollover funds with non-rollover IRA amounts have been repealed.

You should not use this information as a basis for legal and/or tax advice. In any specific case, the parties involved should seek the guidance and advice of your own legal and tax counsel.

In a down economy and with San Diego County’s unemployment rate having gone from 4.8% to 6.5% in the past  year, you might be tempted to do a bad thing – simply cash out your 401(k) plan and bite the bullet on the taxes. Bad idea. First, you probably don’t realize the magnitude of those taxes. You will need to take your income tax bracket for your income this year and apply it to every dollar coming out of your 401(k). Lets say you are in the 28% bracket. Then you will pay a Federal penalty for early withdrawal (this assumes you are younger than 59 1/2) of 10% – now you are at 38% of the funds going to taxes. But wait, you aren’t done yet. There is also a California income tax to consider of at least 6%, taking you to 44%. And then there is the California Penalty for early withdrawal of 2.5%. Now you are at a whopping 46.5% of the funds you take from your retirement plan going to State and Federal taxes.

So, I think you can see that taking these funds without trying every other option available to you just isn’t a good idea. It will take you years to make up for the loss – and the truth is that you will never make up for it since you will have lost the time value of those dollars that are no longer invested on your behalf. For the sake of your long term financial well-being, make it your place of LAST RESORT to go for money to make it on to the next profitable job. Afterall, it may be just around the corner. You just don’t know right now.

It would be much more prudent to do a Direct Rollover of your retirement funds to a Traditional IRA and aviod any income tax consequences. Once this is done, you have complete control of your retirement dollars. If you do eventually find that you have to take some of those funds early and pay the penalties, you can only take what you absolutely have to take. You won’t be restricted by the withdrawal rules of the employer’s plan.

If you don’t know how to get that done efficiently and with little cost, you can contact me at Charles@Oncubic.com.

Charles L. Stanley CFP® ChFC AIF®
Oncubic LLC
3655 Nobel Drive Ste 340
La Jolla CA 92122
Telephone: 888-619-5666 x506
Email: Charles@oncubic.com