Employers can offer two basic types of pensions to employees: defined benefit plans and defined contribution plans. A defined benefit plan is a traditional pension that pays you a certain amount of money when you retire. A defined contribution plan such as a 401(k) doesn't guarantee you a set retirement benefit. When you change jobs or get ready to retire, you can take a lump sum or roll your pension money over into an IRA to defer taxes.
How Pensions Are Taxed
Depending on how your pension is structured, your benefits are either fully or partially taxable when you start making withdrawals. Your pension benefits are fully taxable if you didn't put in any of your own money, if your employer didn't withhold contributions from your pay or if you received all your contributions tax-free in previous years. If your pension plan allowed you to contribute after-tax dollars, you won't pay any tax on the part of your benefits that represents a return of your initial investment. Generally, you'll also have to pay a 10 percent early withdrawal penalty if you receive any pension benefits before you turn 59 1/2.
Direct Rollover Benefits
When you're ready to move your pension money to an IRA, you'll have the option of a direct or indirect rollover. A direct rollover means that your plan administrator or trustee transfers the money to your IRA for you. Typically, when you take money out of your pension the plan administrator is required to withhold 20 percent for federal taxes -- but the biggest benefit of requesting a direct rollover is that the 20 percent withholding doesn't apply when the money is transferred from one trustee to another. You also won't have to worry about the early withdrawal penalty since no part of the money is considered a distribution.
If your plan doesn't allow direct rollovers, you can still transfer your pension benefits to an IRA by yourself. When you do an indirect rollover, the plan administrator sends the money to you directly. The 20 percent federal withholding applies unless you ask for the check to be made out to the IRA that you're planning to deposit the money into. If the 20 percent is withheld, you'll have to make up the difference when you roll your pension over. Otherwise, the IRS will count it as taxable income and the 10 percent early withdrawal penalty may apply.
If you're doing an indirect rollover, you'll have 60 days to deposit the money into your IRA. If you don't, the IRS will consider it to be a distribution and you'll have to pay tax on the whole amount. Certain states also require you to pay taxes on this income.
Some pension plans require you to start taking minimum distributions from your account when you turn 70 1/2, even if you're still working. These types of distributions can't be rolled over into an IRA to defer taxes. You'll also have to decide if you want to roll your benefits over to a traditional or Roth IRA. A traditional IRA lets you deduct your contributions but your benefits are taxable when you start making withdrawals. You don't get a tax write-off for putting money in a Roth IRA but qualified withdrawals are tax-free.
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