The best way to avoid tax penalties with different 401k rollover options is to understand how these different rollover options work and which one is most likely to create a tax burden for you. It’s also important to understand what these options are called and to ask for what you want by name when you request a rollover plan. As always, any 401k taxes or penalties on your money are your responsibility.
Two Types of 401k Rollover Options
The two main types of 401k rollover options are direct and indirect. In an indirect rollover, you request the money from your old 401k plan, receive a check from your former account provider and invest it yourself in another retirement account, such as an IRA. There are several consequences to this type of rollover that you’ll want to avoid, the first being an automatic 20% withholding that comes off the top before you receive any money. Secondly, any time retirement money comes into your hands, you run the risk of the funds being considered a 401k withdrawal or distribution, rather than a rollover.
Strictly speaking, you have a limited amount of time – usually 60 days – to avoid these penalties by getting your money properly deposited and reinvested into a new retirement account. By having the money in your hands, it becomes your responsibility to know and adhere to this window of time, and to be responsible for filing and paying for any taxes that may come due within that fiscal period. While this is a perfectly legal operation, indirect 401k rollovers have, by their very nature, this additional level of complexity that makes this option difficult for most investors – especially in light of the fact that a better option exists.
The better option is a 401k direct rollover. In a direct rollover, the 401k funds are transferred directly from one retirement account to another. Your 401k account balance goes from account manager to account manager and is never placed into your hands. The two things to remember here are that you must initiate the request with the manager of the new or target retirement account, and that you must use the exact term “direct rollover” to describe what you want. This legally binds the managers involved in the transaction to perform a direct 401k rollover and will help you avoid tax penalties.
In addition, you should know that a direct 401k rollover is a reportable event according to IRS rules and regulations. However, this does not mean that it’s a taxable event. Direct rollovers are the better choice when performing a 401k rollover, as they maintain the tax deferred status of your money – which is, of course, why you’re doing this with a retirement account to begin with.
To avoid 401k tax penalties, choose the rollover option that ensures that your 401k funds are transferred directly into a new, qualified retirement savings vehicle, such as an IRA. This will not only help you avoid tax penalties, but withholding and early withdrawal fees as well.