Tax advice good idea for settlement in retirement account

A reader recently asked how to handle a lawsuit settlement received inside a retirement account. This could happen, for example, if stockholders sued a publicly traded company for manipulating the stock price.

Is receiving the settlement a taxable event? Will your contributions to the retirement account be limited that year? If the rules are followed correctly, the answer to both questions is no.

First, the settlement check needs to be made out to the custodian of your 401(k) account and distributed directly into that account, not to you individually. Second, you need to ensure the custodian codes the deposit as 401(k) earnings or as a dividend, not a contribution. In essence, the settlement represents a return of investment losses that you, as a stockholder, have suffered. It is important that you review the settlement documents with your tax adviser and work with your custodian to ensure the receipt of funds is recorded correctly.

The next question is what to do with the settlement. You may decide to keep the money in the existing retirement account or roll it over to your new employer’s plan or into an IRA account. You should make this decision based on your own needs and priorities, and it is best to have a professional assist you with this decision.

Does a Roth conversion make sense? The Worker, Retiree, and Employer Recovery Act of 2008 expanded the rollover rules to allow taxpayers to roll over non-Roth distributions directly from qualified retirement plans to Roth IRAs. (Previously, to accomplish this, the taxpayer needed to first roll a distribution over to a traditional IRA, then convert that IRA to a Roth IRA.) By converting to a Roth, all future earnings inside the Roth will be tax free. The downside is you pay ordinary income tax on the amount you roll into the Roth.

Caution: If you pay the taxes out of your retirement account, the IRS treats the tax payment as an early withdrawal and you will be hit with a 10 percent penalty unless you are 59 ½ or older. For example, you transfer $100,000 to a Roth with a tax rate of 25 percent. If you pay the $25,000 in taxes from your retirement account, you will be hit with a 10 percent penalty on that $25,000 withdrawal.

As a result, a Roth conversion typically only makes sense if you are able to pay the taxes from another source, such as other taxable investments or cash savings, being careful to leave sufficient emergency reserves. It is usually recommended to have 3 to 6 months of living expenses in a liquid savings or money-market account at all times.

The good news is that for those who convert in 2010, the IRS has taken the sting out of the tax bill by allowing you to spread the tax obligation over two years, with half due in 2011 and half in 2012.