Rollover Rip-off: How the Government Steals Millions from the Unemployed

Many of the newly-unemployed receive a surprise present from Uncle Sam-a swift kick. Sounds hard to believe? Let me expose a scam that robs millions of Americans of their life savings just when they need them most and tell you how to steer clear.

I worked behind the counter of a major bank for 4 years, have been a proofreader and copy editor for one of the largest tax publishers in America, was licensed to sell mutual funds and variable annuities, have prepared my own taxes for over 30 years and have switched multiple times between employment and self-employment. I have rolled-over over a half-dozen of my own accounts and have never lost a dime.

Lets begin by defining terms. All retirement accounts are not equal. The accounts that I wish to discuss in this article are the 401K plans, 403B plans, 457 plans, defined benefit plans and defined contribution plans at your place of employment. Your pop would have called them "pensions, " although technically this refers only to "defined benefit plans" based on years of service, age of retirement, and life expectancy-the kind calculated by an actuary-not "defined contribution plans" where benefits are calculated on how much you contribute and your investment performance.

IRAs are self-funded and the participant takes the initiative to contact the bank or mutual fund to set one up. There are three types: The Contributory IRA where you make contributions out of your earned income each year up to the maximum IRS allowable limits. A sub-type of this is a Spousal IRA, which allows a worker to make contribution on behalf of a non-working spouse based on his or her own earnings. Finally there is the Roll-over IRA. This is the account that will receive funds transferred from your former employer's plan.

Here is the heart of the scam: Roll-over has at least 3 different meanings. Furthermore, "Rollovers" from one IRA to another are handled completely differently than "Rollovers" from your ex-employer's plans to your "Rollover" IRA. Confusing isn't it? There is a reason, the government wants it that way.

Please engrave this on your brain: When leaving a job before age 59½ , never accept a check made payable to yourself. The government will take 20% of your money off the top and force you to redeposit 100% of the original sum to a qualified account within 60 days.

If you cannot, you will be subject to an excise tax of 10% in addition to taxes at your highest marginal rate on any money that you don't re-deposit within 60 days to a "Qualified Account." That is to say, the retirement account of your new employer or the "rollover IRA" that you yourself establish at the bank or investment house of your choice. Even more commonly, this mistake will lead to your frittering away your entire retirement savings.

Once upon a time, the word "Roll-over" simply meant a transfer from one retirement account to another. But then the government spin-masters got involved. Terrible unemployment during the Reagan administration led to the Federal government having to give large amounts of money to the states to fund unemployment extensions. Reagan, no great friend to the poor, thought, "What better way to fund benefits to the unemployed than by taking the retirement savings of the jobless?

Hence, "rollover" now has three different and conflicting meanings, namely:

1. A general term that refers simply to transferring funds from one retirement plan sponsor to another.
2. A way of transferring funds that involves having a check made payable to yourself instead of directly to a plan--danger Will Robinson--never do this.
3. A type of IRA that has been funded by money transferred from an existing account, rather than through fresh contributions.

Here is what this maddening obfuscation means in practical terms:

Suppose after working in yea old salt mine for ten years, Mr. Cratchit accumulated retirement savings of $100, 000. Let us say his manager, Mr. Scrooge decides to toss him to the curb so that he can hire that new chicky he has his eye on. If Cratchit takes a check made payable to himself:

Original Savings: $100,000 less 20% to the IRS: $20,000. Check to Cratchit: $80,000

The government requires that the full $100, 000 dollars be deposited to Cratchit's Qualified account - the retirement account at his new job or his roll-over IRA - within 60 days. If he lacks the scratch, too bad, so sad. The excise tax alone on the $20, 000 forwarded to Uncle Sam is $2, 000 and that does not include several thousand dollars of income tax that must also be paid. And since $20, 000 is such a huge sum, threadbare Bob Cratchit can easily be bumped from his normal 15% bracket into 36% or more. The combined loss? Easily $10, 000 taxes and penalties on the $20, 000 the government already has. And that does not include State or local income taxes which may be due as well on the amount.

And that is a best-case scenario. God forbid Bob mistakenly deposit his money into his savings account and leave it there he could easily be out $50, 000 or more in taxes and penalties. That is assuming that he does not spend one dime of his "retirement" savings.

Shell-shocked employees can see decades of savings vanish in a heartbeat. To avoid this, you must instruct the employer not to cut a check payable to you. Next, locate a bank or a mutual fund that you would like to do business with and speak to a new accounts person about opening a rollover account with them.

Your new account can be funded by two different methods:

Some plans will do all the work for you. They will take get in contact with your personnel department and instruct them to forward the money directly. In this case, 100% of your original money will land in the new account.

Some plans make you do a little more work (or you may prefer to be more hands-on). In that case, you will have them mail a check made payable to the plan sponsor for benefit of, your name, IRA. For example: Bob Cratchit decides to open a new IRA at Vanguard funds. His check will read: Vanguard funds, for benefit of, Bob Cratchit, IRA.

This special language renders the check non-negotiable to any account other than a rollover IRA in your name with a specific financial institution serving as a trustee. In practical terms, it establishes a money trail and proves to the IRS that the funds will be used as intended: to fund a retirement account as provided under the tax code. The new plan sponsor stands between you and premature disbursement of the funds and takes responsibility for reporting where every dime of the money is.

Sometimes the easiest option is best. If your former employer is willing, you may wish to leave the funds in the existing plan. In this case, you may be forced to pay some pretty stiff plan expenses over time, but your funds will be safe from IRS looting.

You may be forced to dip into your retirement funds to help you through a long period of unemployment. If you follow my advice and have the funds sent directly to your rollover IRA at a bank, mutual fund or other financial institution, you will be able to control how much money you take and are subject to taxes and penalties on. Furthermore, once you have used the direct transfer method to create your new retirement account, you will retain the option to "borrow" funds for up to 60 days once a year without penalty as long as you redeposit those funds into another roll-over IRA.