Mandatory Withholding For Plan Distributions
Administrators of qualified plans making distributions which are eligible to be rolled over are required to give a written explanation to participants who arc about to receive a plan distribution. This notice must be given at least 30 days (7 days for some plans) and not more than 90 days before the distribution.
This explanation should cover
A. Special tax treatment for lump sum distributions, e.g.; 5-year and 10-year averaging (not available for IRAs or TSAs).
B. Potential income tax penalties for distributions prior to age 59¼.
C. If the plan is a pension or profit sharing plan subject to the "Joint and Survivor" rules, an explanation of these rules must also be provided along with various waiver forms. This material allows a participant and spouse the option to "elect out" of the joint and survivor annuity requirement, if they so desire.
D. Regular Rollover Rules; If the plan distribution is made directly to the participant; he or she has a 60 day period to roll the funds into an IRA to defer the tax. However, the plan administrator is required to withhold 20% of the plan distribution made to individuals, even though the distribution is rolled into an IRA within the 60 day period. The amount withheld is sent to the IRS as an estimated income tax payment.
Potential Problem
Assume a hypothetical distribution of $100,000 from a qualified plan to the participant. The administrator is required to withhold 20% (or $20,000) of the distribution.
If the participant takes the remaining $80,000 and rolls it into an IRA, he or she will be taxed on the $20,000 which was withheld by the IRS, because it is considered to be a taxable distribution. There will also be a penalty tax of 10% on the $20,000 if the recipient is less than age 59 1/2, unless certain exceptions apply.
To avoid this problem, the distributee could borrow $20,000 and thereby place the full $100,000 into the rollover IRA.
The following year, the IRS would refund the $20,000 it withheld and the loan could be repaid.
Direct Rollover Option
To avoid the potential problem illustrated above, the administrator must notify plan distributees of the direct rollover option. The distribution is then made directly to the new IRA or a new qualified plan. This deters the tax and avoids the withholding rule.