In this article, we will discuss how to avoid mandatory withholding when converting an IRA. We will divide the article into subsections containing detailed information about the topic.
Introduction
Mandatory withholding is one of the common problems individuals face when converting their retirement accounts to an IRA. Often, people withdraw their funds from their retirement accounts instead of properly converting them to an IRA. This results in federal and state taxes being owed, along with an early withdrawal penalty. Furthermore, you will miss out on future growth of the money you withdraw.
What is an IRA Conversion and Why is it the Best Way?
An IRA conversion is a relatively straightforward process where you transfer the full amount of your eligible account balance to an Individual Retirement Account (IRA). If you do not request the IRA conversion correctly, a mandatory withholding tax of 20% will be deducted from the amount owed to you. Therefore, it is essential to check this with your retirement account custodian and the IRA institution before making the conversion decision.
An IRA conversion is often the best option for many reasons, including:
- Avoiding a 10% early withdrawal penalty if you are under the age of 59 and a half.
- Continuing to grow your retirement funds and deferring tax payments until you withdraw the funds later in retirement.
- You may be able to find a broader range of investment options compared to those available in your company plan, allowing you to optimize your overall investment diversification.
Examples of Mandatory Withholding Impact and IRA Conversion
Example 1:
Derek decides to resign from his job with a 401K account balance of $50,000. He does not intend to convert his account and chooses to withdraw the funds at that time. He will receive a check for $40,000, as 20% ($10,000) must be withheld. If Derek later decides within 60 days to convert his full account balance, he can do so. However, he must provide the original withheld tax amount ($10,000) to complete the conversion. He will not be able to recover the withheld funds until he files his tax return next year.
Example 2:
Assume the same scenario as above. If Derek had properly requested the IRA conversion from the beginning, he would receive a check for the full amount of $50,000 made payable to the IRA institution.
Example 3:
The 20% withheld in taxes may be a small part of the amount Derek will ultimately have to pay if he does not convert the account and receives the full amount. He will not only pay the higher taxes on the distribution (which may be higher than 20%), but he may also be subject to a 10% early withdrawal penalty if he is younger than 59 and a half, and possibly state income taxes as well.
Example 4:
This time, Derek is converting the remaining $40,000 after the mandatory withholding. He will be subject to taxes and a 10% penalty on the $10,000 that was not distributed. This is certainly better than the total distribution, but it is still worse than a successful conversion of the full balance.
Conclusion
An IRA conversion is a way to save on taxes and achieve future growth of the funds set aside for retirement. You have the option to convert your retirement account to an IRA if you decide to resign, change your job, or leave your current employer for any other reason. However, it is essential to check with your retirement account custodian and the IRA institution before making the conversion decision. You should also consider the potential limitations and challenges you might face in this process.
An IRA conversion is not always the best decision. There are other options available, such as staying in the old retirement plan, completing a conversion to a new employer’s plan, or cashing out. You should evaluate the available options and choose the best one based on your personal and financial circumstances.
Done
Update the article by Scott Spann.
Source: https://www.thebalancemoney.com/ira-rollovers-how-to-avoid-mandatory-withholding-2894616
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