However, in some cases your old 401(k) plan may have access to desirable investments that you couldn’t otherwise access, or possibly you have access to other benefits from participation, such as availability of a financial advisor.  As long as the overall costs remain low in the plan, you might want to leave the funds there.  Plus there are also some additional benefits inherent within 401(k) accounts that are not available to IRAs – you can read up on the reasons to leave your money in the 401(k) in the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k).

On the flip side, there are certain things that you can’t do in a 401(k) (or other Qualified Retirement Plan) that you can ONLY do with an IRA while you’re under age 59½.

IRA-Only Options

With an IRA, there is no penalty for withdrawal for (click the link following each for more detail):

• Health Insurance Premiums while unemployed – §72(t)(2)(D)
• Qualified Higher Education Expenses – §72(t)(2)(E)
• Qualified First-Time Homebuyer Expenses – §72(t)(2)(F)
• Qualified Reservist Distributions – §72(t)(2)(G)

And none of those are available without penalty from your 401(k).  Of course you would have to pay tax on the distribution, but otherwise you can take the money for those purposes.

In addition, setting up a Series of Substantially Equal Periodic Payments (SOSEPP) is generally easier to qualify for and to set up from an IRA than from a 401(k), so this may be an additional reason to consider rolling over.

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Mistakes With NUA

Moving too quickly – if you roll over your funds from the Qualified Retirement Plan (QRP) without first checking to see if there can be a benefit from the NUA treatment of company stock in the QRP, you’ve lost the chance to do so.  Always check for NUA possibility within the QRP before making any rollover moves.

Not moving quickly (completely) enough – if you have determined that NUA treatment can benefit your situation, you must move ALL of the funds from the QRP within the same taxable year.  If you moved your NUA stock out first and planned to rollover the rest of the account into an IRA or other employer plan, you must follow through within the tax year – delaying even one day beyond the tax year end will break the NUA option and cause the distributed stock to be fully taxable.

Taking RMDs in an earlier year – if you retired in an earlier year, and began taking Required Minimum Distributions (RMDs), once that tax year ends and you have not taken your Lump Sum Distribution to enact the NUA option, you no longer have the NUA option available to you.  This is due to the fact that the NUA option is available ONLY after a triggering event, and the entire balance must be withdrawn in a single tax year.  If another triggering event were to occur – disability or death – then the NUA treatment could still be available.

Selling out of NUA-potential stock in the QRP – if you have significant holdings of your company’s stock in your QRP, chances are at some point you’ll get nervous about holding too much stock in a single company.  Obviously, you don’t want to overexpose yourself to a volatile stock – but it may not make sense to sell all the stock, either.  If the stock has appreciated over a significant period of time, you might want to maintain a position simply to take advantage of the NUA treatment.

On the other hand, if you’re concerned that the stock is going to drop like a rock, (remember Enron? Worldcomm? CitiGroup? Countrywide?) you should ignore the concept of NUA altogether – you shouldn’t let tax laws wag the financial responsibility dog.  Besides, if the stock drops there wouldn’t be any NUA treatment anyhow.

Not understanding NUA – if you don’t understand it completely, your chances of getting it right are small.  This is a very strict set of rules (aren’t they all though?) and simple moves in the wrong direction can break the option altogether, potentially causing a major tax hit.  It’s also important for your heirs to understand NUA – or make sure that they will work with your NUA-savvy advisor before they make any moves.

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On the other hand, as a surviving spouse you also have the option of moving the funds from the original account into an account in your own name – which will usually produce better distribution options at your passing, or at least giving you the flexibility to improve the distribution options.  The problem with this move is that once you have moved the funds into your own account, the exception to the 10% penalty for early withdrawal no longer applies.  So, unless one of the other 72(t) exceptions applies you can not access the funds in the new, rollover account until you reach age 59½.

How to Deal With the Dilemma

How should you deal with the dilemma?  It depends completely on your specific situation, but below are some strategies you might consider:

If you’re in dire financial straits without access to the IRA, leave it in your late spouse’s account, at least until you reach age 59½, and then rollover the funds into your own account.  Since there is no deadline for this rollover, you have the flexibility to treat the account in this fashion.  If the event of your untimely death before rolling over the account would produce undesirable distribution requirements, you can address this by purchasing term life insurance with account proceeds, timing the insurance to expire upon your rollover.

If you’re well-to-do (okay, comfortable, or even rich) or in ill health, you should not delay in rolling over the funds into your own account.  This is because when you’ve made this move, you can be in control of the disposition of the account upon your death.  If for some reason you later need to access the funds in the account and you’re still under age 59½, you can either set up a Series of Substantially Equal Periodic Payments (SOSEPP) unless one of the other 72(t) exceptions applies.

What If the Account Requires Lump-Sum Distribution?

If there is a reason to leave the funds in the deceased spouse’s account but the account provisions require that you take a lump sum distribution immediately, you can roll over the account to an Inherited IRA, maintaining the original owner’s name, essentially acting as if you are a non-spouse beneficiary.  This will give you the freedom to begin taking distributions (these are Required Minimum Distributions, RMDs) from the account, without penalty.  Then you can later rollover the funds into your own account at a later date when you no longer need the distributions or you reach age 59½.  This provides you with the option of receiving distributions in smaller amounts and protecting the tax-deferred status as long as possible – in spite of the provision from the original account that required lump-sum distribution.

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Let’s look at the definition from the IRS…

Definition

Only Eligible Rollover Distributions, or ERDs, can be rolled over, according to the IRS.  The definition that is given is really an anti-definition, explaining that any normally taxable distribution is eligible for rollover unless it fits the exceptions listed.

An ERD is defined as – a distribution that is eligible to be rolled over to an eligible retirement plan. Eligible rollover distributions include a participant’s balance in a qualified plan, 401(k), 403(b) or 457 plan, except for certain amounts that include the following:

• Any of a series of substantially equal periodic payments (SOSEPP) paid at least once a year over:
  • The participant’s  lifetime or life expectancy,
  • The joint lives or life expectancies of the participant and his/her beneficiary, or
  • A period of 10 years or more,
• A required minimum distribution,
• Hardship distributions,
• Corrective distributions of excess contributions or excess deferrals, and any income allocable to the excess, or of excess annual additions and any allocable gains,
• A loan treated as a distribution because it does not satisfy certain requirements either when made or later (such as upon default), unless the participant’s accrued benefits are reduced (offset) to repay the loan
• Dividends on employer securities, and
• The cost of life insurance coverage.

So, as long as the distribution plan that you set up doesn’t fit any of the requirements above and has a payout period of 10 years or less, your distributions can be considered ERDs, and therefore rolled over into an IRA or other retirement plan.

Understand that these distributions will be subject to mandatory 20% withholding if paid out to you.  Plus, you must complete the rollover within 60 days when it’s not done by trustee-to-trustee (or direct) rollover.

Whenever possible, you would want to set up these payments as direct rollovers into your IRA (or other QRP) to avoid this withholding requirement and 60-day limit.  If this can’t be done, you should make up the 20% withheld difference from other savings as you rollover the distributions in order to avoid tax and penalties.

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Applying Early for Reduced Benefit Amount

When you apply early (before your FRA), a formula goes into effect to determine how much your benefit will be reduced.  First, determine how many months there are between your FRA and the age at which you’ll start receiving benefits.  The PIA will be reduced by a percentage based upon the number of months you come up with.  The first 36 months are multiplied by 5/9 of 1%, and any months beyond 36 are multiplied by 5/12 of 1%.

So, if your FRA is age 66, and you intend to begin receiving benefits in the month that you are age 62 and 6 months, your PIA would be reduced by 20% for the first 36 months (36 * 5/9% = 20%) plus an additional 2½% for the remaining 6 months (6 * 5/12% = 2½%) for a total of 22½%.  The maximum amount that the PIA can be reduced is 25% for folks with FRA of age 66, ranging up to 30% for those with FRA of age 67.

When you come up with this reduction factor, it is then applied to your PIA, and the result is your anticipated benefit amount.  You can see in the table below how waiting a few months or years can make a big difference to the benefit amount.  And this change can have a huge impact on your lifetime benefits – because once you start receiving your benefit, it won’t change other than with the annual COLA increases – unless you continue to work while receiving benefits, which could increase your PIA.  The other way to increase your benefit is to take the “do over” – described here.

Delaying Receipt of Benefits to Increase the Amount

If you are delaying your retirement beyond FRA, you’ll increase the amount of benefit that you are eligible to receive.  Depending upon your year of birth, this amount will be between 7% and 8% per year that you delay receiving benefits – which can be an increase of as much as 32½% if you delay until age 70 and you were born in 1941 – when your FRA is 65 years and 8 months, and the increase amount is 7½% per year at that age.  See the table below for the increase amounts per year based upon birth year:

So you can see the impact of delaying receipt of retirement benefits – it can amount to more than 50% of the PIA, when you consider early benefits versus late benefits.  Of course, by taking benefits later, you’re foregoing receipt of some monthly benefit payments; given this, early in the game you’d be ahead in terms of total benefit received.  This tends to go away as the break-even point is reached in your mid-70′s to early-80′s in most cases, which we’ll review in a later article.

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Steps to Set Up a SOSEPP

The first step in setting up a SOSEPP is to figure out just how much you’ll need to take each year.  In the best of all circumstances, your SOSEPP plan will take small enough payments that it will not exhaust your IRA funds… Working with a financial advisor or an actuary, you can figure out how much money is required to support the SOSEPP payments that you require.

Once an amount is determined, a new IRA can be opened and the money required rolled over into that account.  Other IRAs and 401(k) accounts will then hold the remainder of your funds – which provides your savings for future needs, once the SOSEPP is no longer in effect, or a “safety valve” for you to use in the event that you need additional funds at some point.  Of course, taking an additional amount from one of these other accounts would require payment of the 10% penalty (unless one of the other exceptions applies) – but this is much better than taking too much from your SOSEPP IRA and busting the plan, which carries some heavy penalties.

Keep in mind, especially if you’re setting up your SOSEPP early in your life, it will be possible to set up another SOSEPP from a different account should the need arise.  You would just have two series’ going on at the same time, with different variables impacting each series.

In other cases, you may just want to take the greatest possible payment that you can from your collective plans, which can be easily determined when the span of the plan is understood, given your age and the amount in the IRAs.

Several choices are necessary to set up the plan:

• Choose one of the three permitted methods – RMD, amortization, or annuitization
• Choose a life expectancy table – single, joint, or uniform life expectancy
• Choose an interest rate (if using amortization or annuitization)
• Decide whether to use annual recalculation (if using amortization or annuitization)
• Choose the account balance valuation date
• Determine the “period” for your payments.  These can be monthly, quarterly or annually, but must at least be annual, and must be at the same regular interval each “period” once set up.

All of these details must be attended to when setting up the plan, and careful attention should be paid when making these decisions.  If you set up such a plan early in your life (say at age 50 or earlier) you will have to live with your choices for a considerable amount of time.  Understand what each choice means and can mean in the future as you make these decisions.

For more information on the SOSEPP – including all of the methods, the life expectancy tables, and all of the other details, see the IRA Owner’s Manual.

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Withholding Rule For Indirect Rollovers

In general, if you take an early withdrawal (pre-age 59½) from an IRA or a Qualified Retirement Plan (QRP) that includes pre-tax money, the custodian of the account is required to withhold and pay to the IRS 20% of the pre-tax amount withdrawn.  This can still be a tax-free transaction if you finish the indirect rollover process correctly and place the entire amount of the distribution back into an IRA or QRP within 60 days.  However, if you don’t complete the indirect rollover, you’re likely to get a tax surprise…

A transaction like this is called an “indirect rollover”, as opposed to a direct or a trustee-to-trustee rollover.  In the event that you complete the indirect rollover within 60 days, you will need to come up with the 20% that was withheld in order to have a full rollover – otherwise you’ll have to pay tax and a penalty on the amount that was not rolled over.

An Example

For example, let’s say you’re 50 years of age, and you have a 401(k) from a former employer that you’d like to roll over into your IRA account.  The 401(k) is worth $50,000.  For whatever reason, you opted to have the 401(k) custodian send you a check for the amount, which you then plan on sending to the IRA custodian for deposit (within the allowable 60 day period, as an indirect rollover).

Lo and behold, when the check arrives, it’s only made out for $40,000!  This is because the custodian was required to withhold 20%… and so now, since you don’t have any savings to speak of, you can only send the $40,000 over to the IRA custodian.  Guess what?  Come tax time, you will have to include that “lost” $10,000 as income, plus you’ll get to pay a 10% early withdrawal penalty as well.  So if you’re in the 25% tax bracket, you get to pay $3,500 in tax and penalties (25% times $10,000 plus 10% times $10,000).

Now, the original 401(k) that was worth $50,000 is reduced to an IRA worth $40,000 and a tax refund of $6,500 (since $10,000 was withheld and your tax and penalties were only $3,500).  This swift little maneuver has cost you 7% of your retirement plan!  Plus, you’ve lost tax-deferral on $10,000…

ALWAYS Do the Direct Rollover

It is for this reason that, whenever possible, you always should do a direct, or trustee-to-trustee transfer when rolling over IRA and QRP funds to a new account.  When you do a trustee-to-trustee rollover, no withholding applies, so you don’t have to make up any difference, and your tax-deferred amount remains intact.

It’s important to note that in our example above, if you had the $10,000 available to you in savings or elsewhere to make up the difference for the withholding, you could still complete the indirect rollover without tax or penalty by sending a total of $50,000 to the IRA custodian within 60 days.  Then when you file your taxes for the year, that $10,000 withheld would amount to either a refund to you or a reduction in the amount of tax that you had to pay for the year.

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1. Contributions from compensation income. These are your regular annual contributions to the Roth IRA account.  You are allowed (in 2009 and 2010) to contribute up to the lesser of your actual earned income compensation or $5,000 – provided your Modified Adjusted Gross Income (MAGI) is below the limits (see the MAGI article for current year limits).
2. Catch up contributions. If you are over age 50 during the tax year, you are eligible to make an additional contribution of $1,000 (for 2009 and 2010) above and beyond the “regular” contributions (#1 above).  This figure would be reduced if your compensation income for the year is less than the total of the regular contribution plus the catch up contribution for the year.
3. Conversion from a traditional IRA. This is a special sort of taxable rollover from your traditional IRA account to a Roth IRA account.  Ordinary income taxes are owed on the amount converted – but no penalty will be applied to all monies converted successfully from the traditional IRA to the Roth IRA.  Through the end of 2009 there is a MAGI limit of $100,000 – meaning that if your MAGI is above that amount, you are ineligible to do a Roth conversion.  In 2010, this limit is removed.
4. Conversion from a Qualified Retirement Plan such as a 401(k). Much the same as #3 above, you may be eligible to convert funds from your QRP to a Roth IRA account.  See this article for more details on how to accomplish this type of conversion.
5. Rollover from a Roth 401(k). If you have a Roth 401(k) through your employer, with limits that are plan-specific you can be eligible to rollover the funds from the Roth 401(k) to your Roth IRA.  Your own contributions to the account plus the growth can be rolled over tax-free to the Roth IRA account.  There are no income limits on such conversions; however there can be limits on when you would have access to the rolled-over funds, depending upon your age at the time of the rollover, the age of the accounts, and other factors.  See this article for more details on Roth 401(k) distributions.
6. Rollover from an inherited Qualified Retirement Plan (QRP). As detailed here, if you’ve inherited a Qualified Retirement Plan you can be eligible to convert those funds to a Roth IRA.
7. Failed rollovers or conversions. If you have attempted to make a rollover or a conversion into your Roth IRA and for some reason it is disallowed – such as you inadvertently had a higher MAGI than anticipated – the amount contributed to the account (if not recharacterized) will be considered a regular contribution, subject to the following tax consequences:
   • a 6% excise tax per year for any excess contribution that is not removed from the account
   • the distributions from the traditional IRA or QRP (if a conversion) must be included in your gross income
   • the distributions will be subject to the additional 10% penalty for an early distribution not covered by an exception, conversion or rollover
8. Certain military death benefits. As a result of the HEART Act, certain payments of Servicemember’s Group Life Insurance (SGLI) benefits can be rolled over into a with no tax or penalty.  This article provides more details.
9. Qualified reservist distributions. A member of any of the US military reserves that has received compensation during active duty is eligible to place those funds in a Roth IRA at any time during the two years following active duty, without regard to normal contribution limits.
10. Exxon Valdez settlements. Certain individuals who received settlement compensation in connection with the Exxon Valdez oil spill can contribute up to $100,000 of the settlement into a Roth IRA without regard to normal contribution limits.  Individuals include both the original plaintiffs and the heirs of the original plaintiffs.  To be eligible for this contribution, the settlement would be claimed as income in the year received, and the contribution must be made during the same tax year as it is claimed as income.
11. Certain payments to employees of bankrupt airlines. Within 180 days of receipt of payments made in connection with bankruptcy of an airline, these payments or a portion of the payments, can be contributed to a Roth IRA without regard to regular limitations.

Note: #10 and #11 have some fairly narrow requirements; you can find more about these in IRS Publication 590.

If you know of any other ways to contribute to a Roth IRA that I have not covered here, please leave a comment!

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As a person who has inherited an IRA from your spouse, you have the following options if you are the sole beneficiary of the IRA:

• Leave the IRA where it is, and begin taking distributions based upon your own life (see Table I for the factors).  This is the default position.
• Rollover the IRA to an inherited IRA (see this post for more information).  In this case, you’re treating the situation as if you’re a non-spouse beneficiary.
• Rollover the IRA into an existing or new IRA in your own name.  This is the special provision that spouses can use that a non-spouse beneficiary can not.  (Note:  you could also leave the IRA where it is and just begin treating the account as if it was your own – more on this below.)

Rollover Into Your Own IRA

There’s nothing terribly complex about the mechanics of a spousal rollover of an inherited IRA – you simply put in motion the paperwork for a rollover, making sure that both the original custodian and the new custodian are aware of the fact that you’re taking advantage of this special provision for spouses.  It is also possible to leave the IRA in place where it is and treat the IRA as your own – this will become the default if you 1) make a contribution into the account; or 2) fail to take the RMDs as if the account were inherited.

Now you have the IRA funds in your own account – which you can contribute to, convert to a Roth IRA, or whatever you’d like.  Plus, if you’re under age 70½, you don’t have to start Required Minimum Distributions (RMDs) from the account. This brings up the one possible downside that you should be aware of as well, prompting a word of caution…

A word of caution

IF you go ahead and rollover the IRA from your deceased spouse’s account into an account in your own name, if you’re less than age 59½, you do not have free access to the funds in the account – one of the 72(t) exceptions must apply, or you’d be charged the extra 10% penalty in addition to taxes on the withdrawal.  It is for this reason that many inheriting spouses do not take the IRA on as their own account – especially when there is a need to access the funds for income.

One more provision

As mentioned earlier, the provision for the spousal beneficiary to treat the IRA as her own is generally for a spouse that is the sole beneficiary.  There are two ways to resolve this situation if the spouse would like to rollover the account to her own IRA and there are more than one beneficiary.

1. Other beneficiaries could disclaim the inheritance, leaving only the spouse (see this article for more information).  Many times, a well-intentioned IRA owner will designate her spouse and a child or grandchild (or a trust for the whole mob of children and/or grandchildren) as split beneficiaries of an IRA account.  This can bring about unintended results, such as very young children having to take RMDs that they do not need.  By disclaiming the inheritance and leaving only the spouse, the spouse can set up a new IRA in her own name, with the same original, now disclaimed, beneficiary or class of beneficiaries as the beneficiary(s) of the new account. This will fulfill the original owner’s intent, while opening up the account to the extra privileges available to an owner of an IRA versus an inheritant.
2. A somewhat less messy method is available – as a spousal beneficiary, but not the sole beneficiary, you can take a distribution of your entire share from the account, and then roll it over to an IRA in your own name, as long as it’s within the 60-day period following the distribution.  You may need to make up the difference of the withholding – in general a distribution from an IRA will be subject to 20% withholding.  If you don’t roll over the full amount into your own IRA, you will be taxed and perhaps assessed a 10% penalty on the amount that you did not roll into the new account.  Using this method eliminates the disclaimer requirement which might be necessary if there are many other beneficiaries or if the other beneficiaries do not wish to disclaim.  (Note:  This method is STRICTLY for a spousal beneficiary.  A non-spouse beneficiary will bust the stretch IRA by taking a distribution of this type, even if they rollover the amount into a properly-titled account within the time allotted.  Those rollovers should ONLY be done via trustee-to-trustee transfer.)

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What Happens When Your IRA Will No Longer Support Your SOSEPP?

Here’s an example:  You’ve set up a SOSEPP in your IRA, beginning at age 50.  As we all know (see this post for details) you have to keep the payments going until you reach age 59½.  During that time, many things can happen, both positive and negative.  In this case, the IRA began with a balance of $100,000, and your annual payments are $3,000.  Things go fine for the first few years, although your account doesn’t seem to be growing.  So, you decide to take a leap and invest it all in a wild-eyed fund – some Madoff fellow’s running it.  Then, lo and behold, one morning you wake up and find that your IRA balance has become – $12 total.  You’re age 56, so you have three and a half more years that you are supposed to be taking this regular payment of $3,000 from your account!  What do you do?  You’ve read about the crazy penalties for busting a 72t payout plan – yikes!

Options

Calm down.  Take a breath, it’s really not so bad.  There are several options:  You could rollover funds from another account into the IRA, either from another IRA account or a 401(k).  You could also choose to make your one-time change to your SOSEPP plan.  Or, you could choose to let it die, and go on with your life.  The best option is the last one – it allows you to be as flexible as you can be.

If you chose the first option, it certainly would work – and your SOSEPP would just continue on as originally planned.  But what if you have decided at this stage that you really don’t need that series of payments anyway?  And it’s just a pain in the rear keeping up with the paperwork and remembering to take the payment each year…?

The same holds true for the one-time change to the RMD method.  If you did that, now you’d have to re-calculate your payment each year on a very small balance.  Once again, a pain in the rear – so why not just take the third option?

Let it die

If you go ahead and take the last payment out of your account (the remaining $12) and close the account – your SOSEPP is no longer in effect.  You now have the option of starting a new SOSEPP from another IRA account, or just discontinuing the idea of the 72t payout.  If you chose to start a new plan, you’d have to start over with a new five-year or (since in the example, you’re age 56) for three and a half more years until you reach age 59½.

What’s key to understand in this is that, for SOSEPP’s, the IRS considers each IRA account separately – yeah, I know, for everything else, all IRAs are considered as one.  What can I say?  They don’t want you to get too comfortable and start predicting how they’ll move – just when you think they’re gonna zig?  they zag.  So with that in mind, if one account (the one with the SOSEPP attached) runs dry, there’s no penalty if you just drop it and move on with your life.

That’s literally all there is to it.  No penalty, no muss, no fuss.

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