Leaving a job or retiring often means making an important decision about your retirement savings: What should you do with the money in your former employer’s 401(k) or other qualified retirement plan?
Rolling those funds into an IRA can give you greater control over your retirement savings while allowing the money to continue growing tax-deferred. But a 401(k) rollover needs to be handled carefully. A mistake could result in unexpected taxes, penalties or a smaller retirement balance.
Here are two of the most common rollover pitfalls to avoid.
1. Choose a Direct Rollover When Possible
If you decide to move money from a former employer’s retirement plan into an IRA, a direct rollover—also called a trustee-to-trustee rollover—is generally the simplest approach.
With a direct rollover, the retirement plan sends the money directly to the financial institution holding your new IRA. You don’t take possession of the funds, so the distribution generally isn’t subject to federal income tax withholding.
You can set up the IRA before initiating the rollover, even if the account has a zero balance.
What Happens If the Check Comes to You?
Things get more complicated when the retirement plan distributes the money directly to you.
For most taxable distributions from a qualified retirement plan, 20% of the taxable amount generally must be withheld for federal income taxes.
For example, suppose you have $100,000 in a former employer’s 401(k) and request a distribution payable to you. You could receive a check for $80,000, with $20,000 withheld for federal taxes.
If you want to roll over the full $100,000, you’d generally need to deposit the entire amount into the new IRA within 60 days. That means finding another $20,000 to replace the amount withheld.
If you don’t, the $20,000 that wasn’t rolled over may be treated as a taxable distribution. Depending on your circumstances and age, an additional tax may also apply.
You may eventually receive credit for the $20,000 withheld when you file your tax return, but in the meantime, you’ve lost the opportunity to keep that money growing tax-deferred.
The takeaway: If you’re eligible for a rollover, arranging for the funds to go directly from the retirement plan to the IRA can help you avoid this problem.
2. Don’t Miss the 60-Day Rollover Deadline
If you receive the retirement funds yourself rather than arranging for a direct rollover, you generally have 60 days to deposit the eligible amount into another retirement account to complete a tax-free rollover.
The clock generally begins the day after you receive the distribution.
Missing the deadline can cause some or all of the distribution to become taxable. An additional 10% tax may also apply to an early distribution if you’re under age 59½ and no exception applies.
There are limited circumstances in which the IRS may allow a late rollover, including certain situations involving circumstances beyond your control. In some cases, taxpayers may also be able to use IRS self-certification procedures when specific requirements are met.
But relying on an exception is far more complicated than completing the rollover correctly in the first place.
What About Moving Money Between IRAs?
The mandatory 20% withholding rule generally applies to distributions from employer-sponsored retirement plans, such as 401(k)s—not to a trustee-to-trustee transfer between IRAs.
However, if you receive an IRA distribution and want to roll it into another IRA, you generally still need to meet the applicable 60-day rollover rules unless the transaction is structured as a direct trustee-to-trustee transfer.
When possible, having the financial institutions transfer the funds directly can simplify the process and reduce the risk of missing a deadline.
Should You Always Roll Over Your 401(k)?
Not necessarily.
Rolling a former employer’s 401(k) into an IRA may provide greater investment flexibility and make it easier to manage your retirement savings in one place. But leaving money in a former employer’s plan can sometimes make sense, depending on the plan’s investment options, fees and other features.
There may also be situations where other retirement-plan rules make keeping funds in the employer plan beneficial.
Before initiating a rollover, consider:
- Investment choices and fees
- Your ability to manage the account
- Whether you need access to the funds before age 59½
- Whether you have other retirement accounts
- The tax implications of the transaction
- Whether the employer plan offers features that aren’t available through an IRA
A rollover is a financial decision—not simply an administrative task.
Don’t Let a Simple Rollover Become a Tax Problem
A 401(k) rollover can be a straightforward way to take control of retirement savings after leaving an employer. But the details matter.
Whenever possible, consider arranging a direct rollover rather than receiving the funds yourself. If you do receive the funds, make sure you understand the 60-day deadline and the potential tax consequences before moving forward.
If you’re retiring, changing jobs or consolidating retirement accounts, talk with your tax advisor before initiating the transaction. A few minutes of planning can help you avoid an unnecessary tax bill and keep more of your retirement savings working for your future.