If you’re performing a 401k rollover, you’ll want to protect yourself from any and all possible 401k rollover taxes. The big things to keep in mind about maintaining the tax deferred status of your investment are what kind of IRA your money is rolling into and how you should perform the rollover. Keep these two things in mind and you’ll protect yourself from a whole host of potential problems.
In all cases, the investment money is, in part or in whole, yours and you are entitled to it. But if you take the money from your 401k and have it sent to you, that is not a qualified 401k rollover. Your intentions to put the money right back into another retirement account don’t matter – when funds come into your hands, it can be deemed a distribution by the IRS, which falls under a well-defined schedule of fees, withholding and taxes. This is to be avoided whenever possible. In addition, a trustee of the account will have to withhold 20% of the value of the money transferred before they can even initiate the financial maneuver. Other 401k rollover taxes and fees will kick in later in the fiscal period.
There are even some twists to requesting a 401k rollover in the first place. An indirect rollover is one option, but it’s probably not your best one. This transaction can also be called payment then transfer, which gives you some indication of how the IRS views this operation. In this situation, you would receive the proceeds from your 401k, usually in the form of a check, which you would then put into a new IRA.
Know that you have a fairly limited amount of time to accomplish this transaction – hold on to the money too long and not only do you lose potential interest, but the IRS can, and probably will, classify the transaction as a disbursement and you will be charged 401k rollover taxes and penalties. You can avoid this by asking for a direct 401k rollover, which is also called a trustee to trustee transfer. In a trustee to trustee transfer, your money will go from your 401k account directly into another qualified plan. This plan may be another 401k or some other type of IRA – the exact structure of the new IRA usually doesn’t matter (except in the case of Roth IRAs).
This type of transaction is sometimes called a plan to plan transfer – again, the name tells you what the IRS thinks and how they will handle the tax assessment. There are usually no 401k rollover taxes involved in this kind of transaction, as the money does not come into your hands. However, if your money is being moved to a Roth IRA, your tax situation will be a bit different. Because a Roth IRA involves after tax dollars, you will pay 401k rollover taxes on any money moved into a Roth IRA. After all, the money you original paid into your 401k was pretax dollars – no income tax has been paid on that money yet.
The most common mistake made in any 401k to IRA rollover is not making sure that the receiving IRA is active and ready to accept the rollover. Fortunately, this can be avoided by checking with the trustee of the receiving fund. In addition, this trustee is the very person who has to be contacted to initiate the direct rollover, so you can often use this phone call to accomplish two things at once.