401(k) Rollover

From the IRS's perspective, a 401(k) rollover occurs when cash or other assets such as stocks, bonds, and mutual fund shares are transferred from one qualified employer's plan to another 401(k) plan, a qualified retirement plan, or a Traditional IRA within 60 days. This is sometimes referred to as the 60-day rollover rule. Generally, if the taxpayer has not reached the age of 59 1/2, then contributions made to a 401(k) plan on a before-tax basis are eligible for rollover.

It's important to follow the correct process because the tax penalties are quite unattractive. In the next several sections, we outline a simple process to follow, as well as the "be careful" approach that sometimes occurs when attempting a rollover.

Direct 401(k) Rollovers

In a direct rollover scenario, the former 401(k) plan administrator will usually require the accountholder to fill out several forms describing the amounts withdrawn, and the account information for the new 401(k) plan, qualifying plan, or the IRA into which the retirement funds will be deposited.

Direct 401(k) rollovers are the most convenient way to move money from an existing plan into another retirement account. With a direct rollover, the money is transferred from one financial institution to another, and the owner never has to worry about withholding rules or tax penalties. Unless it's necessary to take possession of the funds in an account, a direct rollover is the safest and easiest way to make this transfer.

Payments to Individuals

If the accountholder has not reached age 59 1/2, and they choose to have the money in their 401(k) plan paid directly to them, then immediate tax penalties and withholding requirements may apply. When the money in a 401(k) plan is paid to an individual, there is a mandatory 20% withholding; even if the accountholder intends to deposit, or roll over, the money into a new retirement plan at a future date.

When performing this kind of rollover, it may be necessary to use funds from other sources to offset the 20% withheld. If these funds are not added, then the accountholder may be subject to an early withdrawal tax penalty. Let's look at a quick example to see how this works:

401(k) Rollover Tax Example

Let's say Joe saved $200,000 in his 401(k) plan, and he elects to receive the rollover payment directly. Joe will receive a check for $160,000 from that institution; not the full amount of $200,000. Under the 401(k) rollover rules, Joe will now have 60 days to deposit the full amount ($200,000) into another 401(k) plan, qualifying plan, or IRA to avoid tax penalties.

In this example, Joe had to supply the additional $40,000 withheld, and deposit this money into his new retirement plan in order to match 100% of the amount withdrawn.

If the accountholder is under age 59 1/2 at the time of what is now deemed a 401(k) distribution, and they are not able to follow the above process, then tax penalties will apply. There are two "penalties" that occur if a rollover becomes a distribution:

• Any funds not deposited / rolled over need to be treated as taxable income for that year.

• The accountholder will be assessed a 10% early withdrawal penalty on the 401(k) funds not deposited.