What it means
When you leave an employer, you usually have several choices for your workplace retirement account: leave it, cash it out, move it to a new employer's plan or roll it into an IRA. Cashing out triggers income tax and, for younger savers, a penalty.
A rollover avoids both because the money remains in a retirement account. There are two ways to do it.
In a direct rollover the money goes straight from the old account to the new one, and you never touch it. In an indirect rollover the payment is made to you and you have 60 days to deposit it into the new account.
The indirect method has traps. When money comes out of an employer plan and is paid to you, the plan typically must withhold 20% for tax, so you receive only 80%.
To roll over the full amount, you have to add the missing 20% from your own pocket, and you recover it when you file your tax return. Other rules apply as well.
For IRA-to-IRA indirect rollovers, a limit of one per 12 months applies, but direct transfers between institutions are not counted. Missing the 60-day deadline turns the amount into a taxable distribution, though in some cases the tax authority allows a late rollover.
Rollovers matter to employers too, because they usually need to give departing employees clear information about their options. For individuals, an IRA often offers a wider choice of investments and lower fees than a workplace plan, but some plans offer cheap funds or legal protections worth keeping.
Comparing costs and protections before deciding is a sensible step. Keep records of every rollover.
The old plan reports the distribution to the tax authority on a form, and the receiving account reports the deposit, so the two should match. Filing the paperwork with your tax return, with the amounts shown as rolled over, prevents the tax authority from treating the money as income.
In practice
Real-world examples.
Example
A marketing manager changes jobs and asks her old plan to send her $150,000 directly to a new IRA. The money is never paid to her, nothing is withheld and no tax is due.
Example
A widower inherits an IRA from his wife and chooses to treat it as his own through a rollover into an IRA in his name. The tax rules for inherited accounts differ by relationship, so he checks with an adviser first.
Example
A retiree wants to move her IRA from one provider to another that has lower fees. She asks for a direct trustee-to-trustee transfer, so that the one-per-year limit on indirect rollovers does not apply.
Formula
Calculation
Cash received from an indirect rollover = distribution - 20% withholding
Amount to deposit to avoid any tax = full distribution
An employee's 401(k) balance is $100,000, and the plan pays her a cheque instead of transferring it directly. The plan withholds 20%, which is 100,000 x 0.20 = $20,000, so she receives $80,000. To roll over the full $100,000 within 60 days, she must deposit the $80,000 plus another $20,000 from other savings. If she deposits only $80,000, the missing $20,000 is treated as a taxable distribution, and a penalty may apply if she is younger than 59 and a half.Case study
Seen in the real world.
Whitcombe Engineering is an illustrative, fictional company whose departing employee, an engineer, requested a cheque for his $80,000 plan balance and spent two weeks travelling. The plan withheld 20%, or $16,000, and sent him $64,000.
When he returned he wanted to roll the money into an IRA. To avoid tax on the whole $80,000, he needed to deposit $64,000 plus $16,000 from his own savings within 60 days. He found the cash, completed the deposit on day 52 and recovered the $16,000 as a credit when he filed his tax return.
The illustrative lesson is that a direct rollover would have avoided the withholding and the cash scramble. Whitcombe added a note about direct rollovers to its exit checklist.
Watch out
Common mistakes.
- Taking a cheque made out to yourself and missing the 60-day deadline, when the amount then becomes taxable income.
- Forgetting the 20% withholding on indirect rollovers from workplace plans, when you must replace it from other funds to roll over the full amount.
- Assuming a rollover is always better than leaving the money in the employer's plan, when plan fees, investment choices and legal protections can differ.
Questions
People also ask.
What is the difference between a rollover and a transfer?
A rollover can involve the money passing through your hands, while a direct trustee-to-trustee transfer moves it between institutions without you receiving it.
Is a rollover taxable?
Not if it is done correctly and the money goes into a comparable retirement account within the time limit.
Can I roll over into a Roth IRA?
Yes, but moving pre-tax money into a Roth is a conversion, and the amount moved is added to your taxable income.
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