Can I roll a retirement plan distribution into an IRA?

Answer:

If they're asking this question, an investor probably has a 401(k) or other retirement plan through a former employer. The short answer is yes--most retirement plans allow a former employee to roll their plan funds over into an IRA after they've left their employer's service. However, there's more than one way to do a rollover, and how it's done can be critical.

In most cases, the best strategy is to do a direct rollover. This is a direct transfer of funds from an employer-sponsored plan to an IRA. The administrator of an employer-sponsored plan may send the check right to the trustee of the IRA a former employee has selected. That way, the money never passes through the former employee's hands. Alternatively, the plan administrator may give the check to the former employee to deliver to the IRA trustee. This also qualifies as a direct rollover as long as the check isn't made payable to the former employee. Instead, it should be made payable to the IRA trustee for the former employee's benefit. A direct rollover will avoid tax consequences and penalties.

An investor can also do an indirect rollover, but it's rarely a good idea. Here, the check is made payable to the former employee. When they receive the check, they can cash it and deposit the funds in the new IRA within 60 days. The big drawback: Before releasing plan funds to a former employee, the plan administrator is required to withhold 20 percent of the taxable amount for federal income tax. To make sure they deposit the correct amount, they must replace this 20 percent out of their own pocket. However, if an investor properly follows all the IRS rules for rollovers, they will avoid tax consequences and can get back the amount withheld for taxes when they file their annual income tax return.

An investor can roll a distribution into either a traditional IRA or Roth IRA. If they roll the funds over into a Roth IRA (often called a "conversion") they'll include the taxable portion of the distribution in their taxable income in the year they roll the funds over. (A distribution from a retirement plan's Roth account can only be rolled over into a Roth IRA.)

An investor may not be allowed to roll over certain types of retirement plan distributions into an IRA. Further, when considering a rollover, to either an IRA or to another employer's retirement plan, an investor should consider carefully the investment options, fees and expenses, services, ability to make penalty-free withdrawals, degree of creditor protection, and distribution requirements associated with each option. Consult a tax professional for details.

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