Whether you’ve moved on and want to cut the final ties to your previous employer or just think you could do a better job of allocating your nest egg than the fund managers who call the shots at your 401(k), it can be tempting to look at cashing out a retirement plan and rolling the amount into an existing IRA. The Internal Revenue Service allows this, but the tax implications can be drastically different depending upon how you handle the rollover.
If the administrators of your 401(k) allow it, a trustee-to-trustee transfer is by far the easiest, cleanest way to cash out an old retirement account. Essentially, you notify the employer plan of your intent to close down your account, and provide it with information about the brokerage that administers the IRA into which you plan to put the funds. Your 401(k) administrator will send funds directly to your brokerage, or, in some cases, provide you with a check made out to the brokerage. In this type of transfer, you never come in direct possession of cash-out funds, which greatly simplifies matters.
Cash Out and Rollover
If you don’t have the option of a direct rollover, you’ll need to do a bit more advance planning before you cash out your retirement. When you cash out your 401(k), the IRS requires administrators withhold 20 percent of the balance for taxes. Don’t totally freak out: You’ll get it back as a refund when you file your taxes next year. Here’s the rub: If you don’t roll over the full amount of your 401(k), the IRS treats the remainder as an unqualified distribution and slaps you with a 10-percent penalty on the distribution. To avoid this, you’ll need to have an extra 20 percent of your 401(k)’s value ready to replace the amount withheld for taxes.
If you cash out and take possession of your retirement fund, you’ll need to jump through another hoop in addition to the 20-percent withholding rule: The IRS only gives you 60 days to get the funds back into an IRA. The clock starts ticking when you receive the check, and you’re not granted any additional days if the 60th day falls on a weekend or a holiday. If you miss the deadline, the consequences can be disastrous. You’ll owe the standard 10 percent penalty on an unqualified distribution, and, more significantly, you lose the ability to put it back into an IRA. You’ll be capped at the normal contribution limits -- $5,000 for individuals and $10,000 for couples, with a bit extra if you’re older than 50 -- for contributions to your IRA.
The IRS also requires you to place the same type of asset into your IRA as you took out of your 401(k). While this is rule is relatively straightforward, just remember you can’t get too fancy with your rollover plan. If you receive cash, you can’t purchase stocks and roll them into your IRA after you complete the transaction. Similarly, if your retirement plan contains stock, you’ll have to move it directly into your IRA without liquidating it in the interim. If you fail to adhere to this "same-property" rule, the IRS treats the rollover as a distribution and the rollover as a contribution.
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