Taking a loan from your 401k plan can be a major help if you run into unexpected expenses or find yourself in a financial bind.  However, after the loan has been made, you may run into some interesting challenges that arise if you decide that you want to perform a 401k rollover.  Fortunately, there are few things that you can do to help navigate these rather complex financial waters.

When you take money from your 401k and are still employed by the company with whom you have the 401k plan, you can pay back the loan over time by electing to have a small amount taken out of your paycheck each week.  This, of course, is the best way to pay the loan back and maintain the tax-deferred status of your remaining funds.  Ideally, by the time you’re ready to leave the job; you’ll have paid back the loan and will be able to do a 401k rollover without any complications.

However, the situation changes dramatically when you change jobs.  Under the rules of most 401k accounts, you’ll have a short time – usually only 60 days – to pay back the money that remains outstanding on your loan.  Paying back the loan before you attempt the rollover is usually the best option because otherwise, the money you took out will be treated as a distribution, which could open you up to unnecessary taxes and penalties.

If you attempt to initiate the 401k rollover before paying back the entirety of the loan, the money you received as a loan will be subject to taxes.  In addition, if you’re under the magic retirement age of 59 ½ years old, you may be required to pay additional early withdrawal penalties.  Usually, your loan will be taxed as income, plus 10%.  As an example, let’s say that you took out a loan of $4,000 from your 401k account and your current tax bracket is 25%.  If you attempt a 401k rollover before the loan is paid off, you’ll pay as much as $1,400 in penalties and taxes!

In most cases, what will likely happen is that the financial institution that made the loan to you would hold about 20% of the amount of your 401k account balance and the remainder you owe would come due at tax time, as the 401k plan distribution will be treated as income on your tax return.  Keep in mind that this additional income may push you into a higher tax bracket, causing you to owe even more come April 15th.

Of course, the simplest way to avoid all of this is to pay the 401k loan back before ever attempting a 401k rollover.  With the money safely back in the account, all of these consequences are wiped off the board, and you can treat the rollover just as you would any other transfer.

In fact, the complexity of this issue is one reason why some 401k plans don’t allow loans to their participants.  Some larger businesses enjoy offering this service to their employees, but it’s clear that the headaches that come when an employee takes money from the 401k and then the leaves the business aren’t worth it in most cases.

As you consider your options, keep in mind that one of the greatest advantages of a 401(k) plan is that it allows you to save for retirement on a tax-deferred basis. When changing jobs, it’s essential to consider the continued tax-deferral of these retirement funds,

Rolling over to an IRA also gives you greater control over when you withdraw your money. With a 401(k) plan, you usually can’t start taking withdrawals until after you retire. An IRA is more flexible, since as soon as you turn 59 1/2, you’re allowed penalty-free withdrawals, even if you’re still working.

Similarly, you usually must begin taking money from your 401(k) as soon as you retire. If you have income from other sources and don’t want to take withdrawals from a tax-deferred account that quickly, an IRA will let you postpone withdrawals until April 1 of the year after you turn 70 1/2. In fact, many retired people roll over their 401(k) retirement assets into IRAs to avoid having to take money out.

Four Options:

1. Roll over into an IRA By rolling the money into an IRA, you gain more control, have more flexibility in your investment options, and can benefit from the guidance of an Advisor. Plus, your funds grow tax-deferred. An IRA rollover makes it easy to track these funds by keeping them together.
2. Roll over into your new employer’s plan. Many employers will allow you to move the money from your former employer’s retirement plan into your new plan. Check with your former employer. Keeping your money in one employer retirement plan may be convenient, but you may have limited control over your money and the investment options
3. Keep the money in your former employer’s plan. If your balance is $5,000 or more, you may be able to leave the money in your former employer’s plan. This may be the simplest option, but disadvantages exist. You may have limited control over your money and investment options, and you may find it difficult to keep track of your money through the employer’s administrator.
4. Take your money out of your former employer’s plan. You do have the option to withdraw some or all of the money in the plan. However, the money you take out may be taxable income, subject to a mandatory 20% IRS withholding, and a 10% IRS early withdrawal penalty. These taxes and penalties can drastically reduce the amount of money available to you at withdrawal.

The most common type of retirement plan that’s used by people who are self-employed is known as an SEP IRA.  SEP stands for Simplified Employer Pension plan, and it has been designed specifically for people who are self-employed or who own their own businesses.  This kind of plan allows participants to put up to 25% of their income each year into the account, with a limit of $49,000 – considerably more than traditional IRA or 401k contribution limits.  In addition, the SEP IRA allows you to deduct that amount from your yearly income, minimizing the amount you pay in taxes.

Some self-employed individuals may decide to go with a Roth IRA plan instead of an SEP IRA, but be aware that while this is possible, you can’t deduct the monies that are placed into the Roth IRA from your taxes.  However, when you retire and begin to draw on the money, it won’t be taxed, so you could actually end up saving money if taxes go up during this period.  If you decide to transfer funds from your existing 401k plan into a Roth plan, you will need to make sure that the taxes are deducted at the time of the transfer so that you don’t run into problems later on.

In addition, there are other 401k rollover options that you can consider if you’re self employed, but in order to make the right decision for your retirement goals, you’ll want to discuss all of the possible options with a financial advisor.  Tell the advisor what your long term plans are so that he or she can search out the IRA or 401k plan that will best fit your needs.  In fact, it may be possible to find a type of plan or account that you aren’t familiar with that can result in significant tax savings.

Once you’ve decided on the retirement plan that will work best for you, you’ll need to set up the 401k rollover to go from your existing account into the new plan.  The best method for doing this is through what’s known as a direct transfer or a direct 401k rollover.  In this type of transfer, the banks handle moving the money between accounts, so you won’t have to worry about the tax implications of your 401k rollover.  All you need to do is choose the IRA or 401k plan that will best suit you and your retirement goals, and then have the initial 401k plan transferred over to the new one.

Two Types of 401k Rollover Options

Indirect Rollovers

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.

Direct Rollovers

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.

There are plenty of common reasons to perform a 401k rollover – for example, if you’re leaving a job and want to move your funds to an account that you hold, a rollover will allow your 401k funds to leave with you. Alternatively, you may be disappointed with the performance of funds in an old 401k account and this could be enough to cause you to desire a change.

Once you’ve decided on your 401k rollover options and you know where the money is going to go, you’ll need to decide if you’re going to do a direct or an indirect transfer.  The direct transfer is often viewed as the best option, as it’s done entirely between banks – there’s no middleman and no change in the tax status of your funds.  However, if you do an indirect transfer, then a check for only 80% of your balance will be issued to you.  You then have 60 days to put that money into a qualified account before the remaining 20% will be released.  This is something you want to avoid, as it’s technically considered a cash distribution and can later cause problems with your 401k tax.

Unless you meet the qualifying age restrictions on withdrawing money from your 401k, you don’t want to risk taking out a cash distribution because of the 401k withdrawal penalty.  If you’re under 59 ½ years old, then the money will be removed from the account with a 20% tax withholding and a 10% 401k withdrawal penalty attached to it.  You may be able to recover some of the tax withholding when you file your taxes, but the ten percent penalty is something that will be forfeited forever.

Because of this, you’ll want to make sure that you complete a 401k rollover to either another 401k or IRA account.  If you don’t have an account that’s provided by your employer, you’ll want to open a privately held account that will work for your financial needs.  In order to do this, you’ll most likely want to consult with a financial advisor who can go over all of your 401k rollover options until you’re able to decide on the right one.  The IRA or 401k plan that you choose should be one that will work for your retirement needs now and in the future.

However, there are a number of other retirement plans that your employer might offer you that would allow you to complete a 401k rollover.  You will, of course, need to make sure that the structure of the new account will allow for your 401k investment to be moved.  In addition, you’ll need to decide what kind of transfer option you want to use to complete the transaction.  There are two types of transfers that are used when completing a 401k rollover – direct and indirect.

With a direct transfer, the money is moved between banks and no taxes are withheld.  But with an indirect transfer, the money is issued to you in the form of a check, although you’ll notice that 20% of the total 401k funds will be withheld to balance against potential taxes if you fail to deposit the funds into another qualified plan within 60 days.  If you take the 401k distribution and place it into an eligible retirement plan, then the 20% will be moved into the new account.  If you want to avoid any potential mistakes and the loss of 20% of your account balance to taxation, it’s best to use a direct transfer so that everything is handled for you.

If you’re planning on moving your 401k to Roth IRA, know that taxes will be assessed on your 401k funds; unless your existing account is a Roth 401k (these are rare).  The reason for this is that the money in your 401k was taken out of your check before taxes were paid, but in a Roth IRA, all of the monies in the account have already been taxed.  The difference is that when you retire and draw funds out of a Roth IRA account, you won’t have to pay taxes.  To avoid any problems with the IRS, 401k funds will need to be handled by someone who can deduct the appropriate taxes and report them when they’re moved to the Roth IRA account.

One of the best ways to avoid mistakes when you’re deciding on your 401k rollover options is to discuss all of your choices with a financial advisor.  He or she can help you to find a way to make the most out of your 401k investment.  By working through all of your options, you’ll be able to find the one that will work best for your current work environment and your future retirement plans.

Rollover options are broken down into two general categories, regardless of the type of account you plan to roll your 401k funds over into – indirect and direct.  For tax reasons, you’ll probably want to avoid the former category and choose the later.  In order to do that, however, there’s one thing that you must first consider.

While it may seem overly simplistic, the first qualification you must have before choosing to do a 401k rollover is that you must have an account established that can receive the funds.  This doesn’t mean that you have an account offered to you by a new employer, or that you have the intention of opening a new account.  The new account must be active and mature enough – depending on the rules of your new employer and the IRS – that it’s eligible to receive the funds from your former 401k account.

This is a very easy distinction to overlook, and if you request a rollover that cannot be completed, the 401k funds will be sent back to you as a check.  In this situation, you’ll then become liable for any withholding, penalties and taxes you’re subject to under IRS statutes.  You can avoid this mistake by making a simple phone call to the manager of the new account or fund and confirming its status.

In a direct rollover, the funds move directly from your old 401k account into your new IRA account.  This is a transaction that takes place in different ways (depending on how the fund managers determine is best), but all direct 401k rollovers have one key quality in common – you never see or receive any of the money at the time of the rollover.  This is the best type of rollover because there is minimal work on your part and minimal risk of becoming responsible for taxes or other penalties.

The other type of 401k account rollover is called an indirect rollover.  This type of rollover means more work for you and opens you up to the risk of taxes and penalties if you don’t complete the rollover properly within a very limited and specific interval of time as determined by the IRS.  Even with adherence to the time interval (usually 60 days), it’s still likely that 20 percent of the money you receive from your 401k will be withheld for the IRS.  Depending on how much money you have invested, this can represent a substantial loss – one that can be entirely avoided by properly requesting a direct 401k rollover.

One other consideration you should make when evaluating your 401k rollover options is that you don’t necessarily have to rollover your money.  If your 401k account is performing well and still meeting your short and long term retirement savings goals, it may be to your advantage to leave your money in the old 401k plan.  However, most employees will benefit from the additional investment options and higher rates of return offered by 401k to IRA rollovers.  A good financial adviser can look at your 401k as a part of your overall retirement savings strategy and help you determine the best option for rolling over your account.

As an employee, the major advantage of a 401k plan is that the possibilities for return are limited only by market fluctuations and how much you’ve invested into the plan.  In addition, when you consider the benefit of employer matched funds, it’s easy to see why 401k investments are so popular with employees.  However, as you move from one job to another, you may establish several of these plans over time, leaving with you a patchwork of accounts across many different employers.  It’s at this time that you’ll want to consider your 401k rollover options.

When you leave an employer, you typically have four options to consider with regards to your old 401k funds.

First, be aware that you don’t actually have to move your funds away from your old employer’s account.  However, there are a number of limitations with this strategy.  First, employer-sponsored plans are typically more limited than private IRAs in terms of the investment options available.  Performing a 401k rollover to an IRA could increase your access to better performing investments and higher rates of returns.  In addition, consolidating your old 401k accounts into a single IRA can make managing your retirement investments much easier.

If, on the other hand, you decide not to keep your 401k account with your old employer, you can elect to roll it into your new employer’s retirement plan.  Unfortunately, if you go this route, you’ll likely be subject to similar limitations on your available investment options as you were under your old employer’s account.  Really, the only situation where it makes sense to move your funds into the new employer’s account is if the employer offers matched funds in proportion to the total amount you have invested in the account.

A better 401k rollover option is to move your funds into an IRA (Individual Retirement Account).  This allows your capital to keep growing, and perhaps even exceed past performance as your access to investment options expands.  Remember that if you do decide to rollover the money, you’ll want to ask for a direct rollover.  In this process, the manager of the new IRA will contact the manager of your old 401k and ask that the funds be sent directly to the new account.  This is a reportable event, but the IRS does not consider it to be a taxable event; therefore, the tax deferred status of your investments will be maintained.

As a final option, you can elect to cash out the plan.  Of course, you will have to pay the appropriate taxes and withholding, and if you’re younger than retirement age, you may have to pay an early withdrawal penalty as well.  All of these can substantially reduce the size of your available funds.  Remember that 401k plans are designed to allow you to invest for the future, so taking the cash option likely won’t in line with your goals for retirement.  Think about it long and hard before you take the option of cashing out the 401k account.

As mentioned before, an indirect rollover carries with it the risk of a tax burden.  An indirect rollover occurs when you request that the managers of your 401k plan send the funds directly to you, leaving you with the responsibility of depositing that money into another retirement account.  The first problem with this type of transfer is that you’ll automatically be subject to 20% mandatory withholding, which can significantly diminish the value of your retirement holdings.

In addition, you only have a limited amount of time in which to complete this 401k rollover transfer (typically, 60 days according to current IRS statutes).  If you aren’t able to get this money into a new account within the set period, it will be considered a withdrawal by the IRS.  Unless you qualify for an early withdrawal exemption or are over age 59 ½, you’ll be subject to early withdrawal penalties and the money will be taxed as ordinary income.

Transferring your money in a way that alters the tax status from deferred to taxable usually makes little sense in terms of your investment strategies. After all, the entire reason you have a 401k plan or IRA in the first place is to avoid an immediate tax burden while growing your savings for retirement. These kinds of retirement accounts were set up to encourage savings; the tax deferred status of the money works as your incentive to save for retirement.

Fortunately, there is a very easy way to protect your retirement savings and maintain the tax deferred status they have enjoyed while in your 401k account – contact the trustee of the new IRA and tell him or her to perform a direct rollover.  Doing so will begin a specific process in which the money is sent from your old 401k account to the new IRA.  You, as the account holder, won’t ever see the money, as the manager of the target IRA will make all of the transfer arrangements.

Finally, you should be aware that although the IRS considers a direct rollover to be a reportable event, it isn’t a taxable event.  This means that although they’re informed of the transfer, the IRS won’t expect you to pay taxes on your 401k rollover.

For these reasons, the direct rollover is almost always the best way to move money between retirement accounts.  If, for some reason, you choose the indirect method, you’re risking the tax status of part – if not all – of the money you’re transferring out of your 401k.  In truth, the only real way to be sure you’ll maintain the tax deferred status of the rollover is to use the direct rollover option. Other 401k rollover options open the door to too much risk.

It would be natural to ask why a new account can’t or won’t accept your money.  Money is money, after all – right?  Well, not really.  Different IRA accounts are set up according to different laws and regulations that affect the tax status of the money.  For example, the money may have been taxed already, or it may be invested in a tax deferred state.  You don’t want the IRS to tax the same money twice, while at the same time, the IRS won’t let you have money without taxing it.  Remember that IRAs aren’t a way to get tax free money.  Instead, they’re a way to defer the taxes to a better time for you and to promote savings, which is what the IRS wants.

Once you start a new job, you may have little or no choice about what type of account your new IRA will be.  For example, your employer may offer a Simple IRA, a SEP IRA or a traditional IRA – and each of these account types have different rules for accepting 401k rollovers.  If, on the other hand, you have the chance to open your own IRA, be sure to select a target IRA that will be able to receive funds from your 401k plan.

One general rule to keep in mind is that like accepts like.  For example, if you’re doing a 401k rollover to another 401k account, there shouldn’t be an issue – your money will maintain the same tax status throughout the transfer.  In the case of 401k rollovers, you can also move your funds to a traditional IRA, an SEP IRA, a 403b account or a 457b account (as long as it’s a separate account) without incurring a potential tax burden.  The only exceptions to the rule are Simple IRAs and Roth 401ks, which cannot receive funds from a 401k rollover.

In addition, a Roth IRA can also accept a rollover from a 401k account; however, if you move money from your 401k to a Roth IRA, you will have to pay taxes on the money that is being rolled over.  This is because money invested in Roth IRA accounts is invested after taxes have already been paid, while money in your 401k account has not yet been taxed.  As the IRS won’t let you get away without paying taxes, the money you remove from your 401k plan must be taxed before it can be added to a Roth IRA.

If you have any questions regarding your eligibility for different 401k rollover options, contact the managers of your target account – they will be able to tell you if the rollover can be completed as requested.