When you initiate a 401k rollover, be aware that there are two different rollover options for you to choose from – direct or indirect rollover. The former offers greater protection for your retirement savings, while the latter may expose you to a potential tax burden.
This isn’t to say that indirect rollover options are always a bad choice – just which the circumstances under which they’re the best choice are few and far between.
As mentioned before, an indirect rollover carries with it the risk of a tax burden. An indirect rollover occurs when you request that the managers of your 401k plan send the funds directly to you, leaving you with the responsibility of depositing that money into another retirement account.
The first problem with this type of transfer is that you’ll automatically be subject to 20% mandatory withholding, which can significantly diminish the value of your retirement holdings.
In addition, you only have a limited amount of time in which to complete this 401k rollover transfer (typically, 60 days according to current IRS statutes).
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If you aren’t able to get this money into a new account within the set period, it will be considered a withdrawal by the IRS. Unless you qualify for an early withdrawal exemption or are over age 59 ½, you’ll be subject to early withdrawal penalties and the money will be taxed as ordinary income.
Transferring your money in a way that alters the tax status from deferred to taxable usually makes little sense in terms of your investment strategies. After all, the entire reason you have a 401k plan or IRA in the first place is to avoid an immediate tax burden while growing your savings for retirement.
These kinds of retirement accounts were set up to encourage savings; the tax-deferred status of the money works as your incentive to save for retirement.
Fortunately, there is a very easy way to protect your retirement savings and maintain the tax-deferred status they have enjoyed while in your 401k account – contact the trustee of the new IRA and tell him or her to perform a direct rollover.
Doing so will begin a specific process in which the money is sent from your old 401k account to the new IRA. You, as the account holder, won’t ever see the money, as the manager of the target IRA will make all of the transfer arrangements.
Finally, you should be aware that although the IRS considers a direct rollover to be a reportable event, it isn’t a taxable event. This means that although they’re informed of the transfer, the IRS won’t expect you to pay taxes on your 401k rollover.
For these reasons, the direct rollover is almost always the best way to move money between retirement accounts. If for some reason, you choose the indirect method, you’re risking the tax status of the part if not all of the money you’re transferring out of your 401k.
In truth, the only real way to be sure you’ll maintain the tax-deferred status of the rollover is to use the direct rollover option. Other 401k rollover options open the door to too much risk.