Tax Guide: IRA Rollovers

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Chapter 6: Deferring Income
IRA Rollovers
The First Principle of Tax Planning

he taxation of retirement distributions depends on whether the distributions are made in an annuity or a single lump sum. Annuity payments are taxed as ordinary income as they are received. If any after-tax contributions were made to the retirement plan while you were actively employed, a portion of each monthly retirement payment will be treated as a return of the investment and will not be taxed. A single lump-sum distribution may either be taxed at the time it is received or it may be transferred to a tax-deferred individual retirement account (an IRA rollover).

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If you decide to make an IRA rollover, you must transfer the distribution into an IRA within 60 days of the date the distribution is received. To avoid a 20% income tax withholding, this rollover must be accomplished through a "trustee-to-trustee" transfer. This choice allows you to defer the tax on the lump-sum distribution until you begin to withdraw your retirement funds from the IRA. In the meantime, your money will continue to grow in a tax-deferred account. If you are considering retirement before age 59½, you must also consider the 10% excise tax that generally applies to early distributions from retirement accounts. There are very limited exceptions to this excise tax, which you should explore with your tax adviser who is familiar with your particular situation.

If you receive a single-sum distribution and choose to pay taxes in the year it is received, you may be able to calculate your tax liability using a special five- or 10-year forward-averaging ("lump-sum distribution") election. Special averaging reduces the effective tax rate on qualifying distributions by calculating the tax as if the taxable income were spread over several years. Although the special averaging calculation assumes that the income is received over several years, the full amount of the tax is payable for the tax year in which the distribution is received.

For example, consider a single taxpayer who receives a lump-sum distribution of $200,000 and uses five-year averaging. The amount that this taxpayer has left after paying tax is $160,022. If the same taxpayer had taken the same $200,000 distribution but did not use five-year averaging, then the amount left after tax would have been only $139,229. That is, using five-year averaging saves this taxpayer $20,793.

Most taxpayers need to project the consequences of the decision to elect the IRA rollover versus taking the lump-sum distribution, taking into account their personal circumstances.

Example: A married individual has a retirement accumulation of $200,000 in cash for 1997 and is going to make a decision between (a) a special averaging election for a lump-sum distribution, and (b) an IRA rollover.

If five-year special averaging is elected, the tax will be $39,978, leaving $160,022 to be invested at 9% (fully taxable). The IRA will be invested at 9% as well, but in a tax-deferred environment. The tax rate outside the IRA is a constant 28% throughout the entire projection period.

Figure 6-3 below compares the after-tax accumulation under each alternative.

FIGURE 6-3 After-Tax Accumulations
Year	Rollover IRA	Rollover IRA after tax ^a	After-Tax Distribution ^b
1	$200,000	$160,022	$160,022
5	$308,000	$212,000	$219,000
10	$473,000	$311,000	$300,000
15	$728,000	$465,000	$410,000
20	$1,121,000	$703,000	$562,000
a. Assuming lump-sum distribution using married filing joint tax rate schedules for distributions after Year One. b. Assuming 28% tax rate on income accumulation.

In this example, the after-tax accumulation within the IRA begins to exceed the accumulation outside the plan between Year Five and Year 10. Of course, the crossover point will vary with each specific taxpayer and set of assumptions. Your tax and financial advisers can help you determine the better alternative for you, given your personal circumstances.

Choosing between an IRA rollover and lump-sum taxation depends on how soon the retirement funds will be needed and how much of the funds will be needed. If you expect to withdraw your retirement funds gradually over your retirement years, your overall financial position will be enhanced by making an IRA rollover. If you will need significant amounts within a few years of retirement, you generally will benefit by taking the lump-sum distribution.

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