A 401(k) is a retirement savings plan offered by employers. Both you and your employer can make contributions to these plans. If you leave your job, you can roll over your 401(k) funds into an individual retirement account. If your employer approves, you can do this type of rollover even if you remain on the job.
IRAs can be attractive because they might charge lower fees or offer greater choices. You must observe the rollover time limits established by the Internal Revenue Service or face taxes and perhaps penalties.
Different types of rollovers have their own requirements and deadlines. While trustee transfers have no deadline, plan-to-plan rollovers need completed within a 60-day window.
Performing a Plan-to-Plan Rollover
A rollover occurs when you receive a cash distribution from your 401(k) and contribute it to an IRA. You have up to 60 days to make the IRA contribution once the 401(k) distributes the funds. If you miss the deadline by even one day, the IRS will consider it a taxable distribution. If you are under 59 1/2, the IRS will also charge you a 10 percent penalty on top of any income taxes due.
You can appeal a missed deadline if your employer or bank caused the problem. If you prove the delay wasn’t your fault, you can avoid the repercussions of missing the rollover deadline.
Performing a Trustee Transfer
If you simply want to switch to an IRA while maintaining your current employment, you can have your employer arrange a trustee transfer. Your employer instructs the trustee of the firm’s 401(k) plan to transfer your funds directly to the IRA trustee. This is not considered a rollover, since the funds are transferred rather than distributed.
There is no deadline for completing a trustee transfer. You can request a partial transfer and keep both of your accounts active – this might be useful to separate pre- and post-taxed funds.
Performing a Direct Transfer
A direct transfer is very much like a trustee transfer for employees who leave their jobs. The 401(k) trustee transfers the funds to your IRA without exposing you to the time limits associated with distributions. Usually, this is a complete transfer, as you no longer work for the 401(k) sponsor. If you leave your job under unfavorable circumstances, your employer may refuse to facilitate a direct transfer, at which point you must take your funds as a distribution and observe the 60-day rollover deadline.
IRS Withholding Requirements
If you perform your own rollover, the IRS obligates your employer to withhold 20 percent of your funds in case you fail to complete the rollover within the 60-day window and thus owe taxes on a distribution. But even if you meet the deadline, the IRS will tax and penalize you for the withheld money if it isn't part of the rolled-over amount.
You can avoid this problem if you reach into your own pocket and make up the shortfall when you roll over your 401(k). You will receive the 20 percent back after you next file a tax return. Or you can avoid the problem entirely by having your employer arrange a direct transfer.
Considerations for Like-to-Like Rollovers
If your 401(k) contains only pretax contributions, you avoid taxes by rolling over to a traditional IRA. Should your 401(k) account also contain post-tax contributions, you can’t roll them into a traditional IRA.
You do have the option of transferring post-tax contributions to a Roth IRA, where the funds will grow tax-free. A Roth IRA lets you avoid income tax if you keep your earnings in your Roth for five years and are at least 59 1/2 when you make withdrawals. You can choose to put pretax 401(k) funds into a Roth IRA but you will be taxed and, depending on your age, penalized.
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