If you have a pension plan with an employer, it’s either a defined-benefit or defined-contribution plan. A defined-benefit plan issues a specific pension amount at retirement, while a defined-contribution plan lets you and your employer invest money over time to ensure you’re taken care of when you retire. You can roll over a defined-contribution pension plan to an individual retirement arrangement, but you’ll pay taxes unless it goes into another tax-deferred plan, such as a traditional IRA.
You can roll a defined-contribution pension plan into a traditional IRA without tax repercussions. If you roll it into a Roth IRA, you’ll be required to pay taxes on the amount.
Rolling Over Your Pension
Pensions are easy, as long as you stay with the same company your entire working life. But the average person will change jobs at least a few times over the course of his working life. The exact figure is hard to track, but it isn’t unusual for someone to change jobs a dozen or more times between the ages of 18 and 48.
What does that mean for your pension? If you leave or are fired from your job, you’ll keep your pension as long as you were vested. Vesting refers to the minimum time period an employer requires you to be in a job before the money in that pension is guaranteed. Usually you’re only required to be in a job a few years before vesting occurs, but some employers offer immediate vesting, which means your retirement money is guaranteed on the day you start work.
But if you separate from your employer, you have a choice to make. You can leave the pension alone, where it will remain, continuing to accrue interest, until you reach retirement age. You may find you get a better deal by rolling the amount over into another plan, such as an IRA. As long as you handle your rollover properly, you won’t have to pay taxes and penalties on the amount; failure to handle it correctly can be costly, though.
How to Roll Over
It’s important to note that you must have a qualifying event in order to roll over your pension. You can’t roll over your pension while it’s still active with the employer. Either your employer must be ending the pension plan, or you must have separated from the company. In some cases, a pension plan ends because a company closes or is acquired by another company.
Before you start the process, you’ll need to understand an IRA rollover vs. transfer. They both essentially accomplish the same goal, but they’re handled differently. With an IRA rollover, you’ll deposit the money into another retirement plan or IRA before the 60-day deadline. The difference is clear with an IRA rollover vs. transfer because a transfer has the plan move the money to another plan or IRA, requiring no intervention from you to deposit it. You’ll need to set up an account and provide the information to the plan administrator, but they’ll take things from there.
If your employer issues a lump-sum distribution, it’s important to drop it into a retirement account within 60 days. Otherwise, you’ll pay the taxes due on the amount you kept. Rolling over or transferring the funds continues to defer taxes until you pay them, as long as you roll them into another tax-deferred account.
The 20-Percent Withholding Requirement
When an employer issues a pension in a lump sum to a departing employee, he’s required to withhold 20 percent for taxes. Doing a direct rollover could help you avoid that, but it’s important to be prepared. Before you agree to take the distribution, get in touch with an investment representative or your financial institution and set up the receiving account.
Once this account is in place, you’ll be able to take the information to your employer and request a direct defined-benefit pension plan rollover, rather than having it issued as a payment. If, however, your employer will only give you 80 percent, make sure you put the entire 80 percent into a fund before the 60 days is up to avoid tax repercussions.
Tax Repercussions for Early Distributions
If you’ve weighed IRA rollover vs. transfer and your employer issues your pension as a lump-sum distribution anyway, you’ll have to take quick action. Failure to roll that money into an account within the 60-day limit will result in taxes plus a 10-percent early withdrawal penalty, assuming you’re under the age of 59-1/2.
In addition to that 10 percent, you’ll also be hit with taxes on the money you took. This will be based on your income tax bracket for the year in question and will be lumped in with all your other earnings for the year. If your total income puts you in the 24 percent tax bracket and your distribution was $10,000 after the 20-percent withholding, you’ll lose another $2,400 in taxes, in addition to the 10-percent penalty, if it applies.
Pension Rollover to Traditional IRA
With a defined-contribution plan, money is tax deferred, which means you put the money in pretax, then pay taxes when they take the money out in retirement. The easiest IRA rollover, therefore, will be a traditional IRA. With a traditional IRA, tax is deferred until retirement, making it compatible with the pension plan you already have.
With a defined-benefit pension plan rollover, you’re rolling tax-deferred funds into a tax-deferred account if you choose a traditional IRA. The process should be fairly quick and painless, as long as you either have the distribution in hand or your plan can transfer the funds. There will be no taxes due at the time of the rollover, as long as you do it within 60 days of distribution, and you’ll continue to earn interest tax-free until retirement, at which point you’ll pay taxes on each withdrawal from the plan.
Pension Rollover to Roth IRA
Things get a little more complicated if you choose to do a pension rollover to a Roth IRA. A Roth IRA is not tax-deferred, which means you put in after-tax money, and in exchange, you get to enjoy tax-free distributions at retirement. That creates a problem when you’re transferring tax-deferred funds – that is, funds you haven’t yet paid taxes on – into an account that won’t incur taxes when you take them out at retirement.
For that reason, you can’t simply transfer your defined-contribution pension into a Roth IRA without tax penalties. You have two options:
- Pay taxes on the rollover, which could push you into a higher tax bracket, forcing you to pay a higher rate on all your income for the year.
- Roll the money into a traditional IRA, then convert it to a Roth IRA. You’ll pay taxes on the conversion. You can move the money over gradually, though, reducing your tax burden.
Roth IRA Versus Traditional IRA
Before you choose a defined-benefit pension plan rollover option, you should think carefully about where you’ll be parking your money. The choices you make now will have a direct influence on the money you have at retirement, so it’s an important decision. Although rolling over to a traditional IRA may seem like an attractive option simply because it’s easier, it might be better to take the tax hit now, for a couple of reasons.
One of the biggest reasons to pay taxes now is that you may be better able to afford it than you will when you’re retiring. At that point, you’re looking at a drop in income, unless you’ve invested wisely and set plenty of money aside. You may appreciate being able to keep every dollar coming to you at retirement, versus having to deal with a big tax bill each April.
A second good reason to choose a Roth IRA is that the tax brackets that are in place now may not be as generous when you arrive at retirement. That’s a gamble since there’s no way to know for sure what will happen with tax rates over the years. With such uncertainty, though, you may decide to opt to go ahead and pay the taxes now and give future “you” a break.
401(k) Plans and Rollovers
Although they aren’t pensions, 401(k) plans can operate similarly to a pension plan. You can have a defined-contribution 401(k) that has your employer contributing a percentage to your retirement, just as she would if it were a pension. A 401(k) plan stays with you no matter what happens with your employment, but you’ll still be in the same situation as you would with a pension.
Like pensions, most 401(k) plans are tax-deferred. You aren’t taxed when the money goes in, and when you retire, the Internal Revenue Service gets its money. That means you can roll your 401(k) over to a traditional IRA without issue, but you’ll have to pay taxes when you take the money out. If you choose to move it to a Roth IRA, you’ll have to pay taxes on the amount you convert, just as you would with a tax-deferred pension.
There is a much rarer type of 401(k) called a Roth 401(k). With these plans, your money goes in after taxes have already been taken out on it, which means you’ll enjoy tax-free distributions in your golden years. If you roll your Roth 401(k) to a Roth IRA, you won’t have to pay taxes since the money you put into your Roth 401(k) was taxed at the time you put the money in.
The Five-Year Rule
One thing to pay close attention to before you do a pension rollover to a Roth IRA is the five-year rule. With this rule, you can’t take any qualified distributions from your account until five years have passed since you made the first contribution to that plan. So, if you’re getting close to retirement, moving your funds over into a Roth IRA may not be a good idea.
It's important to note that when you do a rollover from another account into a Roth IRA, the holding period does not count toward those five years. If you open a brand new Roth IRA and move your funds into it, the clock starts on the day you opened the account and made your first contribution, no matter how much time you’ve spent paying into your previous plan.
Pension Protection for Employees
If you have a pension with an employer, you may be worried about the security of that plan. If your company files for bankruptcy, will you still get the full amount? The good news is, in most cases, employees get their funds after a company files for bankruptcy, although it’s never 100 percent guaranteed.
The reason you can rest easier under a pension plan is something called the Pension Benefit Guaranty Corporation. This nonprofit corporation protects private-sector pension plans when they end due to insufficient funds. As of 2018, this program protected approximately 40 million workers in the U.S.
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Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.