A 401(k) plan gives employees the option of having their employer contribute a portion of their salary into a qualified retirement account. Contributions are made on a pre-tax basis, and grow tax-deferred until they are withdrawn, typically after the employee reaches retirement age, or leaves the company. A separated employee can avoid the hefty tax liability for taking a distribution from a 401(k) prior to reaching age 59 1/2 by rolling those funds over into another qualified plan, such as an individual retirement account.
An employee who has a 401(k) and leaves the company, either through voluntary or involuntary separation, typically has the option of taking a lump-sum distribution of the 401(k). The Internal Revenue Service usually treats distributions from a 401(k) as ordinary income in the year it is received. If the employee is under age 59 1/2, the IRS will also assess an additional tax penalty of 10 percent of the distribution.
A separated employee who receives a distribution from a 401(k) has 60 days to roll over the funds into an IRA to avoid incurring a tax liability for the distributed amount. The 401(k) plan administrator is required by law to withhold 20 percent of the total distribution, even if the recipient plans to roll over the distribution. The IRS considers the amount withheld to be current income, which is subject to both ordinary income taxes and the 10-percent tax penalty for early withdrawal. A recipient who doesn't want to pay the taxes and penalty for the withheld amount will have to come up with additional funds from another source, such as personal savings, equal to the 20 percent that has been withheld, and add the additional funds to the rollover IRA.
A separated employee can avoid the 20-percent tax withholding, and any subsequent tax liability, by requesting a direct rollover into an IRA. In a direct rollover transaction, the separated employee authorizes the 401(k) plan administrator to transfer the funds directly into an IRA account, where the funds are received by the IRA trustee. The separated employee never takes direct possession of the funds, so does not incur any current tax liability.
A separated employee has the option of rolling over only a portion of the distribution from the 401(k) into an IRA. The portion that is rolled over will continue to received tax-deferred treatment. Any portion of the distribution that is not rolled over will be treated as ordinary income, and if the separated employee is less than 59 1/2 years of age, that portion will be subject to an additional 10-percent tax penalty.