Know the rules to avoid big mistakes.
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By Sue Stevens, CFA, CFP, CPA | 02-15-07 | 06:00 AM | Email Article

Even if you haven't been contributing $4,000 to an IRA each year, it's still possible to end up with a lot of assets in this investment vehicle. For example, if you have a company retirement plan, like a 401(k), you may choose to roll into an IRA when you leave the company or retire. A "rollover" IRA is often one of the biggest assets in someone's retirement nest egg.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

You may also find that you've inherited someone's IRA. There are special rules you need to be aware of that can help you stretch out the value of that IRA for many, many years. That can be a plus when trying to manage taxes.

Rollover IRAs
When you leave a job or retire, you'll have a couple choices about what to do with your 401(k) plan. You can usually leave your assets in the company plan and take distributions when you're required to do so at age 70 1/2. Of course, you can also tap that money sooner--you're allowed to take distributions beginning at age 55 without incurring the 10% early distribution penalty (unlike a traditional IRA where you need to be 59 1/2 to avoid the penalty). Or you can do what most people do--roll your 401(k) assets over to an IRA.

You can also roll over your money to a new company retirement plan. But if you think that might be a possibility in the future, you must be sure not to commingle those company retirement-plan assets with other IRA money in advance of the rollover into your new employer's plan. If you would never consider rolling over one company retirement plan into another, then you can roll your company plan into an existing IRA. (The only other potential consideration is if you think you might ever be sued. If so, know that company-retirement plan assets have greater protection during civil legal proceedings than do IRAs.  Usually this is not a major issue.)

It used to be the case that you couldn't roll over a company retirement plan directly to a Roth IRA. That rule changed with the Pension Protection Act of 2006. But the rule doesn't take affect until 2008. Until next year, you can roll over a company plan only to a traditional IRA (sometimes called a rollover IRA). However, once you've rolled over a company plan to a traditional IRA, you can then convert it to a Roth IRA. The conversion would follow the same rules discussed in Tips for Managing Your Roth IRA.

If you have made aftertax contributions to your company retirement plan, you can roll those over to an IRA, too. You'll need to file Form 8606 to let the IRS know that you've already paid tax on those dollars. The IRS treats these contributions similarly to nondeductible traditional IRA contributions.

The Rollover Process
When it comes to rollovers, there is a lot of confusion over just what you can and can't do. Here are some guidelines.

  • If you want to roll over a company retirement plan to a traditional IRA, you'll need to contact your company's human resource department to obtain a form to do a "direct rollover."
  • You'll need to have established a traditional (or "rollover") IRA at any brokerage you choose to receive the proceeds from your company plan.
  • Your company will either transfer the funds electronically to your IRA account or send you a check made payable to the new custodian; the funds, in turn, can be deposited into your IRA account.
  • If you roll over to a traditional IRA, you will have to start taking required minimum distributions at age 70�.
  • If you never plan to roll your company retirement distribution into a new company retirement plan, there's no reason why you can't combine it with other traditional IRAs you may already have. (As I mentioned above, the one exception would be if bankruptcy is a possibility for you; for details, see The Best Way to Manage Your Traditional IRA.)
  • You may be able to simplify your life by paring down the number of IRA accounts you hold.
  • Once your money has rolled over to an IRA, you can invest in just about anything--stocks, bonds, mutual funds, CDs, etc.

Company Stock and IRA Rollovers
If you are one of the millions of retirement-plan participants holding company stock in your company's plan, you'll have two choices at retirement. You can either roll over the company stock to a traditional IRA or take out the shares (known as taking an "in kind" distribution) and pay tax on the "basis" of those shares. (Your basis is the amount your company originally paid to buy your shares; your company will be able to provide this information to you.)

Which option is better? As with most financial issues, it all depends.

If you roll over the company stock into a traditional IRA, you can defer paying tax, perhaps for a long time. Consider this: At your death, your spouse will be able to roll your IRA over into his or her own IRA and continue deferring tax for his or her lifetime and beyond, assuming that the subsequent beneficiary also continues to take out only the minimum amount required. When you do pay tax, though, those distributions will be taxed at ordinary income-tax rates, not at more-favorable capital gains rates.

If you choose to take out the shares of company stock when you retire, you'll pay ordinary income tax on the basis. The amount of growth over the basis to the fair market value of the stock on the date you withdraw it from the plan is known as "net unrealized appreciation." The NUA will be taxed at long-term capital-gains rates when you eventually sell the stock. In addition, if you hold the shares at least one year after withdrawing them from your plan, any appreciation during that time is also taxed at long-term capital-gains rates. (For you tax buffs, this is based on Section 402(e)(4)(J) of the Internal Revenue Code.) With long-term capital gains rates at 15% versus the highest ordinary income tax bracket of 35%, this strategy can be attractive.

So what's the catch? Well, if you use the NUA approach (taking the shares out of the plan and paying tax on the original basis), those shares of stock do not receive a step-up in basis at your death. (A "step-up in basis" means that your beneficiaries get to value the stock as of your date of death. They can then use that value as their basis going forward. The step-up can be very valuable in reducing the amount of tax owed at the eventual sale of the stock.) With NUA, your beneficiaries retain the original basis (which could be quite low) of the shares based on what your employer paid when it contributed the shares to your plan.

Inherited IRAs
If you inherit an IRA, it can be either a traditional or a Roth IRA. In both cases, you'll be required to take required minimum distributions.

The rules for inherited IRAs vary depending on whether you are the spouse of the deceased or someone else. The spouse is allowed to roll over the deceased's IRA into his or her own IRA. Then the normal rules apply to the spouse's IRA.

Everyone other than the spouse treats the inherited traditional IRA as a beneficiary IRA. You cannot make any new contributions to the account, and you must take RMDs over your lifetime. For more on how much you must withdraw, read How to Manage Retirement-Account Distributions.

Summary
IRAs are one of the most popular types of plans for retirement savings. The rules are complex, but by understanding them you will have a better chance of getting the maximum benefit from your money as you build your retirement nest egg.

For more on traditional IRAs, see The Best Way to Manage Your Traditional IRA. For more on Roth IRAs, see Tips for Managing Your Roth IRA.

A version of this article appeared in the July 2005 issue ofMorningstar Practical Finance.

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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