Many employers offer 401(k) or similar retirement plans to employees, but there are still some companies that sponsor traditional pension plans. Under a pension plan, your employer kicks in a certain amount of money to the plan and you're guaranteed a specific benefit once you retire. These plans are typically set up to pay your benefits monthly but you may have the option of taking a lump sum. Lump sum pension distributions can then be rolled into an IRA.
Before you roll over your pension benefits you'll need to decide which type of IRA you want to set up. You can transfer your money to a traditional IRA or a Roth IRA. If you plan to keep kicking in cash to your IRA after the rollover, a traditional IRA gives you a tax deduction for contributions. If you'd prefer to roll your money over into a Roth IRA, the IRS treats it like a conversion, which means you'll have to pay income tax on the amount you're transferring. The upside is that once the rollover is complete, your money will continue to grow tax-free.
The easiest way to transfer your pension to an IRA is to initiate a direct rollover, also called a trustee-to-trustee transfer. With this type of rollover, the plan administrator is responsible for moving the balance of your pension account to your IRA. You provide your IRA account information and the plan administrator can transfer the money electronically or cut a check to the institution that holds your account. The biggest advantage of using the direct rollover option is that it allows you to avoid paying a 20 percent federal withholding tax on the money you're transferring.
If your plan administrator doesn't offer the direct rollover option, you can also transfer your pension benefits to an IRA manually. This means that instead of sending the money to your brokerage, the plan administrator sends a check directly to you. The administrator is required to automatically withhold 20 percent for taxes. Once you get the check, you have 60 days to complete the rollover into an IRA. If you don't roll the money over in the 60-day time frame, then the total amount is treated like income, which means you'll owe income tax on the distribution.
If you opt for an indirect rollover and you're subject to the 20 percent withholding, the IRS considers it a taxable distribution. You can avoid paying additional taxes on the amount that was withheld by making up the difference when you complete the rollover. The amount that was withheld would then be applied towards your future tax liability. You should also keep in mind that if you're under age 59 1/2, an additional 10 percent early withdrawal penalty will apply if you don't make up the withholding difference when you roll the money over.
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