You can roll your 401(k) account over to a traditional IRA with no penalty at all if you do it right. The money then continues accumulating tax-free in your IRA. Do it wrong, and you have to pay income tax on the transfer. You may also owe tax penalties on top of that.
How to Do It
The simplest, safest way to move the money without a penalty is to have your 401(k) administrator send it to your IRA trustee. The alternative is to have the administrator send you a check for the rollover, then deposit the money in your IRA yourself. There's no tax due provided you complete the rollover within 60 days. The administrator will take out tax withholding if it pays out the 401(k) funds to you, but not if it makes the transfer directly to a retirement account.
When it Goes Wrong
If you take more than 60 days to put the money in an IRA, the IRS treats the rollover as a withdrawal. Even if you deposit the money on day 61, you have to count it as taxable income. If you're under 59 1/2, you also pay a 10 percent penalty for early withdrawal. Withholding makes things even more complicated. If you roll over $10,000 and the administrator withholds $2,000, you still have to deposit $10,000 in the IRA. If you don't find the extra $2,000 somewhere else, it becomes taxable.
If you can show that you followed the rules to the letter but the bank screwed up your rollover, you're off the hook. You can ask the IRS for a waiver for other reasons, such as disability, illness, being out of the country or locked up in jail. These waivers aren't automatic. If you spent the 401(k) money you took out, or you took six months to complete the transfer, the IRS may not take your waiver request seriously.
If you transfer your 401(k) to a Roth IRA, the rules change. There's no tax break when you make contributions or rollovers to a Roth, so you pay income tax on the entire rollover. The upside, of course, is that withdrawals in retirement are tax-free. If you withdraw the money directly instead of having the administrator handle it, the 60-day rule and the penalties for breaking it still apply.
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