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For many business owners, retirement planning is a critical component of their financial strategy. Individual Retirement Accounts (IRAs) provide an excellent vehicle for growing retirement savings with tax advantages. However, navigating the intricacies of IRAs, especially when it comes to rollovers, can be tricky. Even minor mistakes can lead to significant penalties, taxes, and lost wealth. Let’s explore two common IRA rollover mistakes and how to avoid them to ensure your retirement savings remain intact.
1. Indirect Rollovers: A Risky Proposition
When transitioning between jobs or retirement plans, many people consider rolling over their retirement savings from one account to another. While this is generally a sound financial decision, the method of rolling over funds matters significantly.
The indirect rollover process occurs when you receive the funds from your retirement account as a check, with the intention of depositing them into another retirement account within 60 days. Although this might seem like a flexible option, it carries several risks.
Why Indirect Rollovers Are Risky
- Mandatory Withholding: When you receive the distribution, the IRS requires that 20% of the amount be withheld for taxes. This means if you receive $10,000, your employer will withhold $2,000, and you’ll be left with $8,000. If you only roll over the $8,000, the remaining $2,000 will be counted as taxable income and subject to penalties.
- 60-Day Deadline: The IRS mandates that funds from an indirect rollover must be deposited into the new account within 60 days. Failure to meet this deadline results in the entire distribution being treated as taxable income, potentially subject to additional taxes and penalties.
The Better Option: Direct Transfers
Financial expert Ed Slott advocates for direct transfers between accounts instead of indirect rollovers. In a direct transfer, the money moves from one retirement account to another without you ever receiving the funds. This method eliminates the 20% withholding requirement and the 60-day deadline, significantly reducing your risk of costly penalties. Direct transfers are straightforward, seamless, and safer for your retirement savings.
2. The Once-Per-Year Rollover Rule
The IRS has implemented a once-per-year rollover rule, which can catch many business owners off guard. Under this rule, you can only roll over funds from one IRA to another once within a 365-day period. Violating this rule can result in hefty penalties and excess contributions that are subject to taxation.
Common Misunderstandings
Many people believe that the once-per-year rule resets at the beginning of the calendar year. However, the rule applies on a 365-day rolling basis, not on a calendar year. For example, if you complete a rollover in December, you must wait until the following December (not January) to execute another rollover.
How to Avoid Penalties
Again, the simplest solution to avoid these pitfalls is to opt for direct transfers whenever possible. Unlike rollovers, direct transfers are not subject to the once-per-year rule, providing greater flexibility and security for your retirement funds.
Additional Considerations for Business Owners
As a business owner, understanding the nuances of IRA rollovers is essential for maximizing your retirement savings. Here are some extra tips to keep in mind:
- Plan Ahead for Rollovers: If you’re planning to consolidate retirement accounts or switch plans, ensure that you consult with a financial advisor beforehand. They can help you avoid costly mistakes and optimize your rollover strategy.
- Consider Roth Conversions: The once-per-year rule does not apply to Roth IRA conversions. Converting traditional IRA funds to a Roth IRA can offer long-term tax benefits, but it’s essential to understand the tax implications before making this move.
- Stay Informed About Changes in Tax Law: Tax regulations surrounding retirement accounts can change, and staying up-to-date with the latest tax law changes will help you make informed decisions regarding your retirement accounts.
