If you're leaving a job, one of the first things you need to consider is what to do with your 401(k) plan. You could move it to your new employer, but what if you don't have a new employer or the company doesn't offer a retirement plan? Now you need to think about moving your nest egg to an individual retirement account. Generally, there's no time limit for an IRA rollover if the cash moves directly from one account to the other. But if you get your hands on the 401(k) funds, then a 60-day clock starts ticking – and the penalties are brutal if you miss the deadline.
Why Roll a 401(k) into an IRA?
IRAs are a way to save for your retirement from your own contributions, which is ideal if you are planning to work for yourself or your new employer does not offer a retirement plan. They also offer certain benefits that 401(k)s do not. For example, while most employer-sponsored plans offer limited investment choices, IRAs put you in the driver's seat when it comes to growing your wealth. Stocks, bonds, money-exchanges, real estate investment trusts, certificates of deposit – you can invest in all of these and more with an IRA.
Like a 401(k), you are supposed to leave the money in the IRA until you retire. Withdraw the money before age 59 1/2, and the tax man will hit you with an early payment penalty equal to 10 percent of the distribution, and you'll have to pay income tax on the amount you've withdrawn. An IRA is more flexible than a 401(k), however, in that you can withdraw up to $10,000 penalty-free before age 59 1/2 to purchase a first-time home or to pay for college expenses.
What Is the Direct 401(k) Rollover Time Limit?
The easiest way to move your money from a 401(k) to an IRA is directly, using a process known as a "direct rollover." Here, the plan administrator will transfer your former plan assets directly from one account to the other, typically using some form of electronic transfer. You won't ever hold the money, and you won't become liable for the early payment penalty or any taxes.
Generally, there's no time limit for directly rolling over a 401(k). You simply complete the paperwork and, when the IRA is all set up and ready to go, someone will press a button (or write a check) and transfer the funds. It all happens seamlessly, and more or less instantaneously.
Ideally, you'll have the IRA set up as soon as you leave your employer. But if you have more than $5,000 invested, most plans let you leave the money in the 401(k) until you decide what to do with it. For instance, you might choose to leave the money in the 401(k) indefinitely if the benefits offered by your old plan are particularly enticing.
For investments between $1,000 and $5,000, the employer can force out the money, but they must help you to set up an IRA first.
What Is the Time Limit for an Indirect Rollover?
When it comes to rollovers, the clock starts ticking only if you perform an "indirect rollover." This happens where the company sends the account balance to you personally, instead of transferring it directly to your IRA. You'll almost always get an indirect rollover if there's less than $1,000 invested in your 401(k) as the employer can send you a check for the money.
The rule here is that you must deposit the funds into your IRA within 60 days of the old account being closed. Miss the deadline – even by one day – and the IRS will treat the rollover as if you made an early withdrawal. In other words, you have to pay income taxes on the fund balance and the 10 percent early withdrawal penalty.
Here's an illustration. If you received a check for, say, $50,000 from your employer and deposited it in your IRA on day 59, nothing would happen. There would be no tax bill and no penalty. But if you deposited it on day 61, your taxable income for the year just went up by $50,000. You also pay a $5,000 penalty if you're under age 59 1/2.
More Snags With an Indirect Rollover
There's another snag with an indirect rollover: tax withholding. Because you're liable to pay taxes if you miss the 60-day rollover window, the IRS requires the plan administrator to withhold 20 percent of the fund balance on account of taxes – on a $10,000 rollover, for instance, you'd only get a check for $8,000. Only now, it's catch-22, because if you don't deposit the full $10,000 within 60 days, you're going to be hit for taxes and penalties. The rule is that you must roll over the exact same amount you took out of the employer plan.
If you reinvest the money by the deadline, the IRS will refund the 20 percent withholding when you file your tax return for the year. In the meantime, you're going to have to come up the extra cash from your own resources.
Advantages to Performing an Indirect Rollover
If you think the 401(k) rollover rules sound brutal, well, it's deliberate. The IRS wants to make sure that your retirement funds stay exactly where they belong – in a retirement account. If the path to performing an indirect rollover was not fraught with peril, people could use their retirement account like an ATM.
It is possible that, for the right investor, an indirect rollover can serve as a valuable short-term loan. If you have a credit card debt, for example, you could use the 401(k) funds to pay off the debt and stop the interest charges from racking up. If you have a Christmas bonus or an inheritance coming in, you could then use that money to fund your IRA.
For most people though, a direct rollover is the safest from a tax standpoint and therefore the preferred way to move retirement money.
Missing the Deadline
Ignorance is not an excuse for missing the deadline – the IRS expects you to know the rules. But if you miss the 60-day rollover window because the institution screwed up, then the IRS almost certainly will waive the deadline. The rule here is that you must have done everything right, and you must get the funds into your IRA within one year of them leaving your 401(k).
In other hardship situations, it doesn't hurt to ask the IRS for more time. The IRS tends to be liberal in granting relief where, for example, a natural disaster, hospitalization or caring for a terminally ill spouse prevented you from depositing the check on time. If you can show that the situation was outside of your reasonable control, then you're in with a shot at getting the penalty waived.
Reporting the Rollover
You can only do one tax-free rollover in any 12-month period, whether that's a direct or an indirect rollover. The 12-month waiting period begins when the money leaves your 401(k), not when you put it into your IRA account.
Your employer will provide a distribution statement 401(k), IRS Form 1099R, reporting that you took a distribution from your 401(k), and your IRA trustee will file IRS Form 5498, reporting that your IRA received a rollover contribution. You need to report the rollover on your 1040 income tax form even if no portion of the fund is taxable. The reporting requirement stays the same for the 2019 tax season when the new 1040 comes into effect.
- Rollovers of Retirement Plan and IRA Distributions | Internal Revenue Service
- Internal Revenue Service: Rollovers from Retirement Plans
- Internal Revenue Service: Rollovers of Retirement Plan and IRA Distributions
- If You Leave (song) - Wikipedia
- JK Lasser: What to Do If You Miss the 60-Day Rollover Period
- Turbo Tax: What Is IRS Form 5498: IRA Contributions Information?
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.