Pension Rollover to IRA: Avoid the 20% Withholding Trap

You've decided to take the lump sum. Now you have one job: get the money into an IRA without the IRS taking a $150,000+ detour. Here's exactly how.

What can be rolled over to an IRA

Not every pension dollar is eligible. Here's what qualifies under IRC § 402(c):

• Corporate defined-benefit pension lump sums. The entire eligible rollover distribution from a qualified plan can move to a traditional IRA tax-free. This covers Ford, GM, Boeing, IBM, UPS, Procter & Gamble, and other Fortune 500 plans that offer a lump-sum alternative.
• Union (Taft-Hartley) multi-employer plan lump sums. If the plan offers a lump-sum option, it qualifies for rollover.
• State and municipal pension lump sums. Many state plans offer a contribution-refund lump sum. Eligible for rollover.
• FERS contribution refund. Federal employees who leave before retirement age can take a refund of FERS contributions plus interest — this is rollover-eligible. The earned annuity itself cannot be rolled over; only the contribution refund.

What cannot be rolled over: Required minimum distributions (RMDs), hardship distributions, and annuity payments already in-pay (you're already receiving the monthly check). Once you've elected the annuity, that stream is locked in — the monthly payments cannot subsequently be converted to a lump sum and rolled to an IRA.

Direct rollover vs. 60-day rollover: the numbers that matter

The 60-day (indirect) rollover — and why it goes wrong

If you ask your employer to send a check to you personally, they are required by law (IRC § 3405(c)) to withhold 20% for federal income tax before cutting the check.

A concrete example: You're 62 and retiring from a major automotive manufacturer with a $750,000 lump-sum offer. You ask for a check.

• Your employer sends the IRS $150,000 (20% withholding)
• You receive a $600,000 check
• You have 60 days to deposit into a traditional IRA
• To avoid any tax on the distribution, you must deposit the full $750,000 — not just $600,000
• You must come up with $150,000 from savings, brokerage accounts, or other funds to make up the withheld amount
• If you deposit only $600,000, the $150,000 becomes a taxable distribution — ordinary income, possibly pushing you into the 32% or 35% bracket in the year of distribution, plus a 10% early withdrawal penalty if you're under 59½

On a $150,000 accidental distribution, the combined federal tax + penalty can easily reach $55,000–$70,000. This is the mistake that costs people the most, and it happens more often than you'd expect.

Direct rollover — the right way

A direct rollover means the money moves from your employer's pension plan directly to your IRA custodian. You never touch it. No withholding. No 60-day clock. No risk.

How to execute it:

1. Open a traditional IRA at your chosen custodian (Vanguard, Fidelity, Schwab, or wherever) before initiating the rollover. You need an account number to give your employer.
2. Request the direct rollover from your employer's pension plan administrator. Tell them you want a direct rollover to an IRA and provide your IRA account number and custodian's address.
3. The plan will issue a check payable to your custodian — typically something like "Fidelity Investments FBO [Your Name]." This check is usually mailed to you to forward, or sent directly to the custodian.
4. Deposit immediately if the check comes to you. Even on a direct rollover check (payable to custodian), deposit it promptly.
5. Your IRA custodian will show the deposit as a rollover contribution (not a regular contribution — no annual limit applies to rollovers).

Traditional IRA vs. Roth IRA: the conversion opportunity

Pension lump sums almost always roll to a traditional IRA — the rollover itself is tax-free because both accounts are pre-tax. You'd owe tax only when you take distributions.

Rolling to a Roth IRA directly is technically allowed (it's a conversion), but triggers ordinary income tax on the entire rollover amount in the year it happens. A $750,000 rollover converted to Roth in a single year creates a federal taxable event at the highest marginal brackets — not advisable for most people.

The smarter approach for those who want Roth exposure: roll to traditional IRA, then execute partial Roth conversions over several years in the window between retirement and Social Security and RMDs (ages 62–73 is the prime window for many people). Convert just enough each year to fill up the 22% or 24% bracket without spilling into 32%. This can convert hundreds of thousands into Roth over a decade without a painful single-year tax hit.

Net Unrealized Appreciation (NUA) — if your pension includes employer stock

Some pension plans — particularly those in manufacturing and certain hybrid plan structures — hold employer stock as part of the plan assets. If your distribution includes employer stock, you may be eligible for NUA treatment under IRC § 402(e)(4), which can substantially reduce your tax bill.

How NUA works:

• The stock's cost basis (what the plan paid for it) is taxed as ordinary income in the year of distribution
• The NUA (appreciation from plan purchase price to fair market value at distribution) is not taxed at distribution — it's deferred until you sell the stock, and then taxed at long-term capital gains rates (0%, 15%, or 20%) rather than ordinary income rates

Example: Your pension distributes $100,000 of company stock. The plan's cost basis is $25,000. The NUA is $75,000.

• If you roll to IRA: All $100,000 is deferred, but future withdrawals taxed at ordinary income rates (potentially 22-37%)
• If you elect NUA: Pay ordinary income on $25,000 now; the $75,000 NUA is taxed at LTCG rates when you sell (15-20% for most people)
• Savings on $75,000: potentially $5,250–$12,750 depending on brackets

NUA only makes sense if: (1) you have substantial appreciation, (2) you're already in a high ordinary income bracket, and (3) your LTCG rate is meaningfully lower than your ordinary income rate. A fee-only advisor who understands this election can model your specific numbers.

Partial rollovers

You are not required to roll the entire pension lump sum to an IRA. A partial rollover is allowed: you can roll a portion to an IRA (tax-free) and take the rest as cash (taxable in the year of distribution). This flexibility can be useful if you want:

• A cash cushion for near-term expenses without taking IRA distributions later
• To pay off a mortgage or debt with pre-tax dollars (though you still owe income tax on the cash portion)
• To fund a large one-time purchase

Be careful: the cash portion counts as ordinary income in the distribution year, potentially creating a large tax bill. If you're under 59½, the cash portion also faces a 10% early withdrawal penalty (with an exception under the "Rule of 55" if you separated from service in the year you turn 55 or later — but this applies to the distributing employer's plan, not to subsequent IRA withdrawals).

State income taxes on pension rollovers

A direct rollover to an IRA defers state income tax as well as federal. When you later take IRA distributions, your state at the time of distribution — not the state where you worked — determines the tax treatment. Some states exempt pension and retirement income partially or fully; others tax all distributions. Moving from a high-tax to a low-tax state between rollover and distribution can be a meaningful strategy, but it should fit your life situation, not just your tax bill.

Common mistakes — and how to avoid them

Timeline: what to do in what order

1. Before separating from employment: Confirm your lump-sum election in writing. Get the distribution date and exact amount in writing from the plan administrator.
2. Before the distribution date: Open the traditional IRA at your chosen custodian. Get your IRA account number and the custodian's rollover instructions (mailing address or wire instructions).
3. Submit the direct rollover election: Complete your employer's rollover paperwork with the IRA account number and custodian information. Confirm they will issue the check payable to the custodian, not to you.
4. Receive and deposit the check (if applicable): If the check comes to your address (payable to custodian), mail or deliver it promptly. Don't let it sit.
5. Confirm receipt: Verify the IRA custodian has received and posted the rollover. Request written confirmation.
6. Investment decisions: Don't be rushed into an allocation. Many custodians default new rollovers to a money market or stable value fund. You have time to develop a thoughtful strategy.
7. Model partial Roth conversions: In years when your income is low, consider converting a portion to Roth — especially before Social Security and RMDs begin increasing your taxable income floor.