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Wednesday, Nov 29, 2023

ROLLOVERS — IRA Rollover Considerations When Leaving a Job

Tax Advantages Offer Potential to Increase Value of Assets

Are you changing jobs or retiring in the next several months? If you’re like many working individuals, you may be covered by your employer’s 401(k) plan or other retirement plan.

When you leave your job, you may have to make an important decision regarding any distribution you may receive from your employer’s plan. As you will see, the decision is complex, and there are many factors to consider, based upon your personal circumstances.

Generally, you have two choices , deferring taxes by establishing an IRA rollover account, or taking the distribution and paying taxes on it.

Deferring taxes: An IRA rollover account has several tax advantages, including the ability to postpone paying income taxes on the IRA assets until you actually receive distributions from your IRA, making the full amount of the distribution available for investment.

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While they remain in your rollover account, all investment earnings, dividends and gains are tax-deferred. You pay no income taxes until you receive distributions. Over time, these tax advantages have the potential to increase the value of your assets significantly.

Paying taxes: While the tax-favored rollover choice is very attractive, the taxable alternative may meet another financial need, such as an immediate source of funds to start your own business.

– Potential Eligibility For Favorable Tax Treatments

You may also be eligible for one of the favorable tax treatments associated with the taxable option, including:

– Forward averaging. Generally, your distribution will be taxed as ordinary income unless you’re eligible for forward averaging, which can result in a tax that is lower than ordinary income tax.

Forward averaging may be used if you have participated in the plan for five years prior to the distribution, are age 59 & #733; at the time of distribution, have never used forward averaging before, and meet certain other eligibility requirements.

Forward averaging became obsolete as of Dec. 31, except for employees born before 1936 who qualify under a special “grandfather” rule. Consult your tax adviser for more information.

– Special tax treatment of employer securities. If your distribution includes securities of the company you work for, you may receive favorable tax treatment on these securities.

You may have to choose to have the lower of your average cost basis or the market value (on the distribution date) of those employer securities included in your taxable income for the year you receive the distribution. The amount would be taxed as ordinary income, unless you are eligible for forward averaging, and would become your new cost basis for these securities. This would be your only tax liability until you sold the securities.

Upon selling the securities, you would be taxed on the excess, if any, of the sale price over your cost basis. The excess, if any, up to the value of the securities on the distribution date, would be taxed as a long-term capital gain regardless of when the securities were sold. Any other gain would be taxed under the capital gain rules.

You may not apply this special tax treatment to employer securities if you roll them over to an IRA. When distributed later from an IRA, all securities are taxed as ordinary income at fair market value as of the distribution date. Also, the distribution that includes employer securities must qualify as a “lump sum” under federal tax law.

As you can see, the decisions you make regarding the treatment of your retirement plan distribution will have a significant impact on your current income tax, as well as your funds available for investment.

Be sure to consult your tax adviser to determine which choice is appropriate for your individual situation before making any tax-related investment decisions.

Druffner is a financial advisor and certified financial planner with Morgan Stanley Dean Witter’s Rancho Bernardo office.


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