An individual retirement arrangement (IRA) rollover involves the movement of tax-sheltered money from a retirement account to an IRA. Under federal tax laws, different rules apply to rollovers between two IRAs as opposed to rollovers involving an IRA and a different type of retirement account. However, you can set up your rollover so that you do not have to contend with any tax complications at all.
When you establish an IRA, a bank or investment firm acts as the custodian or trustee of your money. Likewise, when you participate in a pension plan at work, your employer hires an outside firm to act as the custodian of all the plan participant's money. You can move money between IRAs or from pension plans to IRAs by arranging a trustee-to-trustee transfer. You provide the existing custodian with the contact details of the new custodian and the funds are sent directly to the new custodian. In some cases, the custodian may give you a check, but the custodian makes the check payable to the new custodian and specifies that the funds are for your benefit. You have no access to the funds during the process, so there are no tax ramifications.
If you do not arrange a trustee-to-trustee transfer, then you must physically take possession of the funds and you have just 60 days to re-deposit the money into an IRA. Failure to do so, leads the Internal Revenue Service (IRS) to re-characterize the transfer as a withdrawal. When you rollover funds from a pension plan, the plan custodian has to withhold 20 percent of the distribution amount to cover taxes. You then have to replace those withheld funds with separate funds when you re-deposit the money into your IRA. You get the 20 percent back when you file your taxes for the year.
If you move funds between two IRAs, you can ask the custodian not to withhold any funds to cover taxes. If you do not make such a request, the custodian has to withhold 10 percent to cover federal taxes. As with pension plan rollovers, you have 60 days to complete the rollover and you must replenish the distribution with separate funds and claim back the withholding when you file your taxes. If you fail to complete a pension or IRA rollover, then you pay income tax on the withdrawal amount. You also pay a 10 percent tax penalty if you are younger than 59 1/2, although the Internal Revenue Service waives the penalty in some situations, such as if you use the money to buy a first-time home.
In many states, laws exist that require custodians to withhold funds for state taxes whenever you conduct an IRA rollover. In states including Massachusetts, Maine and Kansas, your custodian has to withhold 5 percent of your distribution amount to cover state taxes. Other states, such as Florida, have no state income tax, which means you only have to contend with federal tax withholdings. To complete a rollover, you have to replenish the distribution with other funds and claim the withholding back from the state at tax time. However, state withholdings only apply to rollovers that you conduct and do not apply to trustee-to-trustee transfers.
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