If you’re receiving a distribution from a retirement account, you face the choice of paying lump-sum taxes or utilizing a rollover to defer taxes. While some special options exist to help certain taxpayers lower their tax burden on lump sum distributions, for many people it makes more sense to roll the money into a traditional IRA. The choice comes down to careful analysis of the costs and benefits of each option.
If you do rollover funds from a tax-deferred plan to a Roth IRA, taxes will be due on the total amount converted in that year. But after age 59 ½, future withdrawals of your earnings will be free of federal income tax once you’ve held the account for at least five years.
When you decide to utilize an IRA rollover, you may choose a direct trustee-to-trustee transfer. The money never passes through your hands, and you can avoid potential tax and penalty problems by doing so. You must also complete the IRA rollover within 60 days of the distribution in order to avoid taxes and penalties.
The benefit of electing an IRA rollover is that it allows your retirement funds to continue compounding with taxes deferred. However, once you reach age 70 ½, you must begin taking the required minimum distributions (RMDs). The first RMD must be taken no later than April 1 of the year in which you reach this age. This is very important to remember, as failing to take an RMD will cause that amount to be subject to a 50 percent income tax penalty.
Since there are both benefits and pitfalls to lump sum distributions and rollovers, weigh each option carefully with your tax advisor before making your final choice. Careful and strategic planning can help you avoid excessive taxes and create a bigger nest egg for your future.