The question, “How should you take your rollover 401k IRA distribution?” has the potential to cause confusion, not to mention tax problems. That’s because, in the eyes of the IRS, a 401k rollover and a distribution are two different types of transactions. And when you’re dealing with the IRS, it’s important to be precise with your terminology.
When money is being moved from one qualified plan to another qualified plan, the transaction is typically thought of and defined as a 401k rollover. If you’re moving your 401k IRA funds to a new IRA, for example, think rollover, not distribution. This kind of IRA rollover transaction may also be called a trustee to trustee transfer, trustee to trustee rollover or a direct rollover.
When money is coming out of your qualified plan and into your hands, that transaction is typically thought of and defined as a distribution. If you’re cashing out your 401k and heading to some island with the funds, for example, think 401k distribution, not rollover. This type of transaction may also be called a withdrawal.
But just when you think you have your terminology clear, there’s another transaction to consider – the indirect rollover. In this type of transaction, your 401k is “cashed out” and a check is issued to you, but you immediately turn around and deposit the money into a new qualified retirement plan. This is a kind of hybrid rollover-distribution, and while it has many of the benefits of a 401k rollover, it also exposes you to some of the risks of a distribution.
You see, 401ks are designed to provide for your retirement. Spend your money before retirement, and not only will you have to pay those income taxes you previously deferred, but you’ll also pay a penalty for your impatience (often called an early withdrawal or surrender penalty).
In light of this, there are really only two ways you should consider taking your rollover 401k IRA “distribution.” First, take that money in the form of a direct rollover. That will minimize your risk of any 401k rollover taxes, withholding and penalties, and will ensure that your money keeps growing for your retirement. Second, if the money must come into your hands, ask that the check be made out to the trustee of the new IRA into which you plan to place the money. Then, deposit the money directly into your new IRA or 401k – not into any of your personal accounts – within 60 days of taking the distribution. This will help to protect you from taxes and penalties, although it may not protect you from withholding.
When it comes to performing a rollover from 401k to IRA, there are lots of rules and regulations to consider. If you still have questions, you can talk to a tax adviser or financial planner, or consult the official documentation at the IRS website. Knowing the right terminology can mean the difference between a transaction that goes smoothly and a mistake that can cost you money.