What it means
When you leave an employer you generally have four options for the balance in the workplace plan: leave it where it is, move it to the new employer's plan, roll it into an IRA, or take the cash. The rollover route is popular because an IRA usually offers a far wider investment menu and lets several old plans be consolidated into one account.
There are two mechanics and the difference between them is expensive. A direct rollover sends the money straight from the old plan to the new custodian with nothing withheld; an indirect rollover pays the money to you first, and the plan is required to withhold 20% for tax.
With an indirect rollover you have 60 days to deposit the full original amount, including the 20% you never received, or the shortfall counts as a taxable distribution. Making up the gap from savings and reclaiming the withholding on the following tax return is possible, but this is precisely why advisers push people towards the direct route.
Pre-tax 401(k) money rolls into a traditional or rollover IRA with no tax charge, whereas converting it into a Roth IRA is a taxable event and the full converted amount is added to that year's income. Some savers do this deliberately in a low income year, but it needs planning rather than accident.
One trade-off is worth knowing before consolidating. Workplace plans can offer institutional fund pricing and, in the United States, stronger federal creditor protection than an IRA, so moving a large balance is not automatically the right answer.
In practice
Real-world examples.
Example
A software engineer with three old 401(k) accounts totalling $240,000 rolls them all into a single IRA. Consolidation cuts her total annual charges by about $900 and gives her one statement instead of three, along with access to index funds her old plans did not offer.
Example
A departing executive takes an indirect rollover intending to use the cash briefly as a bridge loan while a house purchase completes. The sale slips past the 60 day window and the entire balance becomes taxable, an outcome a direct rollover would have avoided.
Example
A small business owner rolls a former employer's plan into an IRA and then, in a year when profits were unusually low, converts part of it to a Roth. Paying tax at 12% on the converted amount rather than at 24% later makes the conversion worthwhile.
Think of it
“Rollover IRA is where retirement money goes when you move it-preserving tax status.
Formula
Calculation
Cost of failing to replace withheld tax = amount withheld x (marginal tax rate + early withdrawal penalty rate)
A saver leaves a job with $180,000 in a 401(k) and chooses an indirect rollover. The plan withholds 20%, or $180,000 x 0.20 = $36,000, and sends a payment of $144,000.
To keep the rollover whole, the saver must deposit the full $180,000 within 60 days, finding the missing $36,000 from other savings. If only the $144,000 received is deposited, the $36,000 is treated as a distribution: at a 24% marginal rate that is $36,000 x 0.24 = $8,640 of tax, plus a 10% early withdrawal penalty of $3,600 for someone under age 59 and a half, a total cost of $12,240.
A direct rollover would have moved the whole $180,000 across with nothing withheld and nothing owed, which is a $12,240 difference created entirely by the choice of mechanism.Case study
Seen in the real world.
This is an illustrative and entirely fictional case. Marla Devane, an invented character, left a manufacturing employer after eighteen years with $310,000 in the company plan. Her new employer's plan had a narrow fund range and higher charges, so she decided to move the money to an IRA.
Her first instruction was misread and the plan issued a payment to her personally, withholding $62,000 and sending $248,000. Recognising the problem, she deposited the $248,000 immediately and used a short term loan from a relative to add the missing $62,000 within the 60 day window, keeping the full $310,000 tax free.
The withheld $62,000 came back as a refund when she filed her return the following spring, and she repaid the loan. The illustrative moral is that the paperwork wording matters as much as the decision, and that a direct trustee-to-trustee transfer would have made the whole episode unnecessary.
Watch out
Common mistakes.
- Choosing an indirect rollover without realising that 20% will be withheld and must be replaced out of other money to keep the transfer whole.
- Missing the 60 day deadline, which converts the entire balance into taxable income and, for younger savers, adds a 10% penalty.
- Rolling pre-tax money into a Roth IRA without expecting the tax bill, since the conversion is fully taxable in the year it happens.
Questions
People also ask.
Can I roll a rollover IRA into a future employer's plan?
Usually yes, provided the receiving plan accepts incoming transfers, which is one reason some savers keep rollover money in its own account rather than mixing it with other IRA contributions.
How many indirect rollovers can I do in a year?
Only one IRA-to-IRA indirect rollover in any twelve month period, though direct trustee-to-trustee transfers are unlimited.
Does rolling over cost anything?
The transfer itself is normally free, but check for exit charges on the old plan and compare the ongoing fund charges at each end before moving.
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