10% penalty due to employer closing 401k and paying it out?

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Topic Author
MHA556
Posts: 100
Joined: Wed Sep 01, 2021 8:01 am

10% penalty due to employer closing 401k and paying it out?

Post by MHA556 »

My kid (on my advice) started a 401k while working a temp job, the 401k was run thru Wells Fargo. Shortly after he was laid off, and ended up in a new job. Meanwhile Wells Fargo apparently decided to get out of the 401k game, and it got shifted to another company (Principal Trust Company) who decided to just close it down as it was a small account. He was sent a letter saying to contact them prior to a certain date if he wanted to roll it over to a new place. He did contact them ahead of this deadline, desiring to roll it over, but they told him they had already mailed him a check to pay it off...

This would be all fine, they withheld 20% for taxes, and I told him to just dump the checks funds into a Roth IRA....comes out as a wash I suppose.

However, isn’t this going to trigger a 10% early distribution penalty as well? The check has now arrived, and it even mentions the 10% IRS penalty- which they caused by paying it out against without his consent.

Seems to me there is no reason he should pay the 10% when their ineptness caused it.

Before I advise him to raise hell with the company, is there any exemption in place for this where he would not have to pay the penalty? Otherwise he is getting hosed, and I don’t like that happening at the start of his saving/investing career, it sets a bad tone.

As far as I am concerned they should pay the 10%, or take back their check and let him roll it over as he wanted to do.

Not an area I am familiar with (taking money out!) so appreciate any advice.
Makefile
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by Makefile »

This is a force-out and they are allowed to do it if the balance was under $1000. (If it had been $1001-$5000, they would only be able to force you out into an IRA).

You are right that there is a 10% penalty on the withheld amount if it was not also rolled over, and since it was withheld, you would have to replace that withholding from other funds. This is because it looks no different than if he cashed out the 401(k), rolled over 80% of it, and kept 20% as spending money.

This is a known unfortunate aspect of 401(k) and similar plans.

Are the 60 days already up? If not, it isn't too late to fix this.
MrJedi
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by MrJedi »

Within 60 days you can do an indirect rollover and it will not be subject to the 10% penalty.
sport
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Location: Cleveland, OH

Re: 10% penalty due to employer closing 401k and paying it out?

Post by sport »

He can roll the amount of the check into a TIRA. Then, the only early withdrawal is the money that was withheld. If he makes up that amount with other money, then there is no penalty. He can get the withheld money back when he files his tax return. I believe he has to do that within 60 days of the withdrawal.
ralph124cf
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by ralph124cf »

A tIRA would count as a rollover, but putting it into a Roth is the same as just taking a distribution. That does not mean that a Roth was a wrong choice, just that you have to pay tax now instead of later.

Since he is young and presumably in a low tax bracket, this may well be an optimum choice.

Ralph
Topic Author
MHA556
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by MHA556 »

Knew you folks would have the answer! Yep a bit over $900 total. He just received the check a week or so ago, so it sounds like he should be able to start a traditional IRA if he makes up the 20% they did withhold. Not sure if he will want to do the Roth option if that does mean he is forced to add the 10% penalty, but if he can at least come out even one way or another I will be happy.

Still doesn’t make up for the fact that they forced him out after saying he had the option to roll it over, but it is possible he missed the small print about accounts under 1k...

Regardless he is happy with it- he actually had some serious growth on his contributions, and they at least cashed him out near the top of the market, so he should be able to come out ahead on the number of shares at least. His new employer has a pretty good program- they do 3% regardless of whether you contribute anything, then will match up to another 4%. He is doing 10% of his own, so he ends up with 17% total going in. They have some decent benefits as well and a good work schedule so all in all this newer job is looking good so far.

Thanks everyone for the info!
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BL
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by BL »

I believe the same penalty works for both the Roth IRA and the tIRA: 10% of whatever amount was not put into an IRA of some type (or possibly to your 401k). So if you get it done within 60 days (don't wait until the last minute!), the only problem is the 20% you don't get until tax-time next year. You need to come up with that amount now in order to get it into the IRA, which is probably more important for the long term if you could be saving it in a Roth which will grow tax-free if you leave it past the age and 5-year requirements. The dollar amount of the penalty won't be much, but getting the 20% into a Roth IRA could be a big deal.

Yes, he will also have to pay income tax on any money converted to Roth instead of leaving it tax-deferred in a tIRA, but he will never have to pay tax on it again upon withdrawal, even if it doubles many times in his lifetime.
water2357
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by water2357 »

The 10% premature distribution penalty does not apply to assets that you convert to a Roth IRA, even if you convert the assets before reaching age 59½. Any amount distributed that is not converted (for example, funds used to pay your tax bill) may be subject to the 10% premature distribution penalty.

If you want the money to end up in a Roth, put it in a Traditional IRA first (i.e. roll it over within 60 days) and then convert it later to a Roth paying the normal income tax. Watch any restrictions on how many rollovers you can do in a particular time period. Not sure about conversions, might be ok if you do a direct trustee to trustee transfer to the Roth. It's too late for you to do a direct transfer to the Traditional, with the check in hand you just have to be sure it gets into the Trad IRA with the 20% withheld before the 60 days is up from the time the 401k paid out the money.
cas
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by cas »

MHA556 wrote: Sat Dec 04, 2021 12:34 am He just received the check a week or so ago, so it sounds like he should be able to start a traditional IRA if he makes up the 20% they did withhold.
Make sure that when the funds are deposited into the new IRA (within the 60 day limit) that the custodian is clearly notified that these funds are a 60 day rollover. This will involve something like checking a "60 day rollover" box somewhere on an electronic or paper deposit ticket. If he tries to do all of it online and does not see any way to check a specific 60-day-rollover indictator, he may need to get a paper deposit slip and snail mail it in or call a customer service rep and ask how to get the deposit designated as a 60 day rollover. (e.g. Fidelity didn't used to have a 60-day rollover checkbox on their electronic deposit ticket, but they did on the paper deposit ticket.)

The custodian *has* to know it is a 60 day rollover so that they fill out the tax paperwork that they send to the IRS correctly.

And your son will also need to fill out his income tax return correctly to indicate to the IRS that it was a 60-day rollover. (The 401(k) plan will send him a 1099-R that he will need to include on his taxes.)
HomeStretch
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Re: 10% penalty due to employer closing 401k and paying it out?

Post by HomeStretch »

Your son should make it clear to the new IRA account brokerage that the deposit is a rollover and not a contribution so his 2021 Form 5498 receives is coded correctly. He will also receive a 2021 Form 1099-R from WF for the distribution. Both will be reported on his 2021 tax return.

Indirect rollovers may generate an IRS notice letter. Your son should keep a copy of the check, envelope it came in with postmark date (if there is one) and copy of the statement showing the date and amount deposited into a new IRA in order to substantiate, if asked by the IRS, the rollover was completed within 60 days.
sidwin516
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Joined: Fri Feb 26, 2021 1:46 am

Re: 10% penalty due to employer closing 401k and paying it out?

Post by sidwin516 »

Had this happen to my wife. Make sure if u decide to do ira u roll the full amount before the 10% they took our. Then at the end the year the 10% will be a fed tax credit. My cpa told me that. I was kind of bummed to have to front the 10% but glad I did.
twh
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Joined: Sat Feb 08, 2020 2:15 pm

Re: 10% penalty due to employer closing 401k and paying it out?

Post by twh »

water2357 wrote: Sat Dec 04, 2021 5:56 am The 10% premature distribution penalty does not apply to assets that you convert to a Roth IRA, even if you convert the assets before reaching age 59½. Any amount distributed that is not converted (for example, funds used to pay your tax bill) may be subject to the 10% premature distribution penalty.

If you want the money to end up in a Roth, put it in a Traditional IRA first (i.e. roll it over within 60 days) and then convert it later to a Roth paying the normal income tax. Watch any restrictions on how many rollovers you can do in a particular time period. Not sure about conversions, might be ok if you do a direct trustee to trustee transfer to the Roth. It's too late for you to do a direct transfer to the Traditional, with the check in hand you just have to be sure it gets into the Trad IRA with the 20% withheld before the 60 days is up from the time the 401k paid out the money.
^^ THIS is the way to proceed. One finer point...there are no limits on the number of tIRA->Roth conversions you can do in any time period. There is confusion here because there are limits on indirect tIRA->tIRA. The IRS thinking here is they get their tax money now, so they are happy to allow iIRA->Roth to happen as often as you want.
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