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August 01, 2024 at 02:01 PM
What You Need to Know
- While it often makes sense to consolidate retirement savings, clients need to be careful.
- At stake is a potential loss of their wealth through penalties, excise taxes and fees.
- The once-per-year rule doesn’t affect the ability to transfer funds from one IRA trustee directly to another.
Financial advisors are well aware of the tax rules that affect retirement withdrawals, required minimum distributions, Roth conversions and rollovers. Clients, though, can often make major wealth-killing mistakes when managing their retirement savings.
Such mistakes are becoming increasingly common, according to financial planning expert Ed Slott, as Americans find more of their household wealth concentrated in retirement accounts.
A growing number of individuals are making “fatal errors” in the rollover process, Slott said, especially as people change jobs more frequently and face tricky decisions about whether to consolidate accounts from past jobs.
Slott shared this warning in a video interview hosted by Christine Benz, Morningstar’s director of personal finance and retirement planning. In the discussion, Slott pointed to some key mistakes that people can make during the rollover process — potentially robbing them of a substantial portion of their wealth through penalties, excise taxes and fees.
Advisors need to be fully up to speed with requirements applying to the timing and technique of compliant rollovers, Slott said. Falling short, he added, is a surefire way to tarnish their reputation while potentially raising legal liability.
Here are two potential pitfalls to avoid:
Mistake No. 1: Making Indirect Rollovers
Slott is not a fan of rollovers.
“And by ‘rollovers,’ I mean when you take the money out … and you get a check and roll it over, say, to an IRA. … You have to complete rollovers within 60 days,” he said. “It sounds like a long time, but a lot of people miss the boat on this thing.”
Slott’s advice is to do only direct transfers from account to account. This approach eliminates the risk of late reinvestment while allowing clients to avoid the uncomfortable experience of “mandatory withholding,” generally at 20% of the rollover amount.
For example, if clients received a $10,000 eligible rollover distribution from their 401(k) plan, their employer must withhold $2,000 from that distribution. If the recipients later decide to roll over the $8,000, but not the $2,000 withheld, they will report $2,000 as taxable income, $8,000 as a nontaxable rollover and $2,000 as taxes paid.
People in this situation must also pay a 10% additional tax on early distributions on the $2,000 — unless they qualify for an exception.
