The Government Wants to Make Your 401(k) Rollover Taxable

By Tim Berry, JD - Email Editor

Date : 05-Feb-2008

When you leave an employer, you are going to be asked to make one of the biggest financial decisions of your life. Do you want to roll over your retirement plan or not?

It only makes sense due to the dollars riding on the decision that you should seek out help. However, under a little known government ruling, this decision could be one of the most expensive decisions you will ever make.

Back in 2005, the government issued an interesting opinion. This opinion stated if you paid a financial planner to help you with decisions regarding your retirement plan, your advisor would become a fiduciary to you and those retirement plan assets.

To put it differently, if you are confused by the investment options with your employer’s retirement plan and hire a financial planner to help you figure out these options, once the financial planner receives a fee for helping you with the account, they are considered a fiduciary to you.

This by itself does not present a problem. After all, this only makes sense, doesn’t it? If you rely upon someone for advice regarding your retirement funds, they should be a fiduciary to you. Here is the problem with this situation.

In that exact same ruling, the government is of the opinion that you probably have engaged in a prohibited transaction if the following occurs:

1. You ask your advisor/fiduciary for advice on what to do when you leave your employer.

2. The advisor tells you to roll the 401(k) money that you have with your employer plan into an Individual Retirement Account (IRA) managed by that advisor.

So what is a prohibited transaction? It is a death sentence for your IRA account.

The tax code says that if you engage in a “prohibited transaction” with your IRA assets, the account ceases to be an IRA account. This means the value of the account is now treated as if it was fully distributed and currently taxable. Yep, you read that right, you now owe taxes on what you thought was a tax-free rollover.

The real tragedy is that thousands, if not millions, of people are going to fall into this trap unknowingly. One major investment firm even has a marketing campaign about something they call the “retirement red zone”. They define the retirement red zone as the 5 years before and the 5 years after you retire. Presumably, their purpose in creating this “red zone” is to urge individuals to seek out financial planning advice before they retire from their company.

Just imagine the unknowing client who does in fact hire an advisor sometime within the 5 years before they retire from their employer. Since financial advisors are paid by the assets they manage, high on the advisor’s list of what to do is suggesting the client rollover his funds to an IRA managed by the same advisor.

If the client follows that advice, they have just run afoul of this little known government ruling. Depending upon the age of the client, they are probably going to lose anywhere between 30 to 50% of their account value, an account they worked years to build up. Also, don’t forget that a retiree who takes this advice will lose any future tax deferred growth on the account as well.

Yep, this sounds like a red zone.

If you are getting ready to retire and you want to take control of your retirement funds, make sure you talk to an advisor who knows the prohibited transaction rules inside and out so you don’t lose your nest egg!

Tim Berry, JD
National Speaker on the subject of Self Directed Retirement Plans