Losing a job or changing jobs is a challenging time, not least because of all the financial information you have to consider. How will you cover the bills when your income is interrupted? And what will happen to the employer-sponsored retirement account that you've been building up for past few years? You might assume that you can simply shift the retirement funds from an old 401(k) plan into a new one. The truth is a bit more complicated – and you risk losing 20 percent of your fund if you're not clear on the rules.
When you move money from one IRA to another IRA, it's called an IRA transfer. A rollover happens when you move money between two different types of retirement accounts.
What Happens to Your 401(k) When You Change Jobs?
You may think about cashing out your 401(k) when you leave your current employer, but that's a terrible idea. Unless you're age 59 1/2, cashing in the account means you'll have to pay income tax on the withdrawal plus a 10 percent early withdrawal penalty. The Internal Revenue Service has the power to waive the early withdrawal penalty for certain hardship conditions such as medical or education expenses, but you still have to pay income tax on the distribution.
To avoid a tax sting, most people choose to move their employer-sponsored account to another plan with a different employer, or move their funds to an individual retirement account. IRAs offer a tax-advantaged home for your 401(k) fund, and you can use the money to buy stocks, bonds and other financial instruments to help you save for retirement.
By law, your employer must allow you to move your money into another retirement account of your choosing. There are various options for doing this, however, and each has its own rules and tax implications.
What Is an IRA Transfer?
A transfer occurs whenever you move funds between two retirement accounts of exactly the same type: a traditional IRA into another traditional IRA, a Roth IRA to a Roth IRA, or an old 401(k) to a new 401(k). If you want to move funds between two different types of accounts, for example, a 401(k) to an IRA, that's called a rollover, not a transfer.
Transfers are relatively easy to arrange because the plan administrators do all the heavy lifting. Simply tell the administrators of the old and new accounts that you wish to make a switch, and the two custodians will organize everything on your behalf. You won't even see the money as it gets transferred from one fund directly to another.
The "hands-off" nature of a transfer is its biggest advantage. Since the money is never in your hands, the IRS has no right to charge taxes or early withdrawal penalties. You don't even have to tell them about it. In fact, you could move very large sums of money from one IRA to another several times a year and you would never have to notify Uncle Sam or worry about a potential tax penalty. As far as the IRS is concerned, an IRA-to-IRA transfer is simply a non-event.
What Is the Difference Between a Rollover and a Transfer?
If you move money between two different types of retirement account, for example a 401(k) to an IRA, that's called a rollover. There are two types of rollovers. With a "direct rollover," the plan administrator will transfer funds directly from the old retirement account to the new one. So, it looks a lot like a transfer. Since you don't see the money, there's no early withdrawal penalty and no liability for taxes.
With an "indirect rollover," the plan administrator will release the money in your plan to you. Since you're physically holding the money, the withdrawal is a taxable event. The IRS will withhold a percentage of the distribution for taxes.
IRA Rollover Rules: Direct Rollovers
Direct rollovers are easy to understand and even easier to implement. All that's happening is money is being shifted from your current account to your new account. Usually, the cash will move directly by some type of electronic transfer, meaning you don't have to lift a finger. Sometimes, the plan administrator will send you a check made out "for the benefit" of the new IRA. Now, your only job is to mail the check to the new account.
Even as you wave the check around in your hands, you're not really holding the money. That's because you cannot cash a check that's made out to someone else. The money is not considered part of your income and is entirely shielded from income taxes and early withdrawal penalties.
IRA Rollover Rules: Indirect Rollovers
Indirect rollovers are a whole different ball game. With this type of rollover, the plan administrator will cash out your old account and send you a personal check for the full amount of funds. Since you now have control over the money, it is considered to be your personal taxable income. Per IRS rules, the administrator must withhold a percentage to help cover the income taxes that you owe on the money.
How much will be withheld? It depends on the type of account you're rolling from and to. Your administrator will withhold 10 percent of the fund when you rollover from an IRA to a qualified employer plan. Roll the other way, from a 401(k) or 403(b) to an IRA, and 20 percent will be withheld. What's more, if the rollover occurs before you reach age 59 1/2, you must pay the 10 percent early withdrawal penalty on top of the withholding.
Can You Avoid the Penalty on an Indirect Rollover?
If you reinvest the whole of the funds in another qualified retirement account within 60 days of the old account being closed, the IRS will not charge you any taxes or penalties. The administrator will still have to withhold 20 percent of the money, but the IRS will give you this back in the form of a tax credit.
This sounds simple enough but watch out for the catch – you must reinvest the exact amount that was in the retirement account including the money that was withheld.
Here's an example. Suppose your 401(k) is worth $20,000. With an indirect rollover, the administrator will close the plan and send you a check for $16,000 ($20,000 less 20 percent). To avoid income taxes and the early withdrawal penalty, you're going to have to put the full $20,000 into your IRA within 60 days, which means you'll need to come up with $4,000 of your own money.
Why Would Anyone Choose an Indirect Rollover?
For many savers, the potential cash flow problem caused by the tax withholding pushes them toward opting for a direct rollover. Plus, there is a lot of potential for making a mistake with an indirect rollover. Depositing the wrong amount of money – or the right amount of money even one day late – into your new account could cost you thousands of dollars in penalties and taxes, for example.
That said, no single option is right for everyone. Some people like the idea of getting their hands on a large sum of money, even if it is just for 60 days. If you think you can make a decent return on the cash through a short-term investment opportunity, then choosing an indirect rollover may be a better option for you.
Do You Have to Report an IRA Transfer Vs. Rollover?
You're free to do as many IRA transfers as you like without telling the tax man anything – there are no reporting requirements. That's not the case with a rollover. Regardless of whether the rollover is direct or indirect, you are limited to just one rollover in total per year no matter how many retirement accounts you have. And, you must report the rollover distribution on your 1040 income tax form even if no taxes are owed. This position is not expected to be any different in the 2019 tax season when the new, streamlined form 1040 comes into effect.