Maybe you’ve changed jobs. Maybe you’ve found that your old employer 401k isn’t performing as well as it could be. Or maybe you have multiple options to rollover 401k accounts from previous employers and you’ve decided that it’s time to get your nest eggs into fewer baskets. For whatever reason, you’ve determined that it’s time to rollover your 401k plan. Now, the challenge becomes how to accomplish that while avoiding tax penalties in your 401k rollover options.
Your 401k, as you may remember, is funded with pretax dollars and your taxes are deferred until you begin taking distributions in retirement. Most people can anticipate a more advantageous tax situation when they retire, which is why it makes sense to defer taxes until that time. This means that you haven’t yet paid income tax on the money in your 401k account. Unfortunately, taxes can be deferred, but they cannot be eliminated entirely. Your goal, when moving your money out of your 401k plan, is to continue to avoid paying taxes and penalties, if at all possible. Doing so keeps more money in your pockets for longer.
The key to avoiding tax penalties when rolling over your 401k is to make sure that money gets into another qualified IRA, so that it can continue to enjoy its tax deferred status. This means choosing the right kind of rollover and choosing the right kind of IRA into which your 401k funds are delivered.
There are two kinds of rollovers. In the first, and some would argue best, type of rollover, your funds are moved directly from your 401k to your new IRA. This transaction is called by different names, including direct rollover, trustee to trustee transfer and direct transfer. The key is that the transaction involves primarily the managers of the old and new IRAs – you or your bank account never see a check with your old 401k funds.
The second kind of rollover gives rise to more potential tax penalties. In this transaction, you essentially cash out your 401k account, receive a check and then deposit the money into a new 401k or IRA. Here’s the kicker – any time you receive the proceeds from a retirement savings vehicle, there is a potential tax burden created. Until those funds are actually deposited safely in a new qualified plan, there is the possibility, at least in the IRS’s eyes, that this transaction could be an early withdrawal or disbursement.
In general, this means that the trustee of your old employer 401k may have to withhold a percentage of the funds to offset potential tax penalties. If you fail to get those funds deposited into the new account within the time interval the IRS specifies, you will not only owe income taxes on the money, but penalties for early withdrawal as well.
Does this mean that you should never choose an indirect rollover? No. There may be reasons or situations where it is actually the best choice. As long as you’re aware of your options and their potential consequences, you can make an informed decision about what’s best for you. If you have additional questions, know that the IRS provides information about 401k rollovers online. A visit with your tax accountant or financial professional can also help you confirm that you are making the right choice with your 401k rollover.