401 K Rollovers
The Internal Revenue Code allowed for-profit business to establish 401(k) as a form of a salary-reduction plan starting in 1978. Since then, 401(k) plans have grown rapidly in popularity and now are the most common form of a defined contribution plan. Most employers match at least a portion of their workers’ contributions as part of a savings and thrift plan.
Tax deferred contributions can be made to 401(k) plans as well as after tax contributions. Both tax deferred and after tax contributions are limited by law and change each year.
Asset Ownership Differences
Rollover procedures are different because assets are held differently in a 401k plan than in an IRA. The money you have in a 401k is held in a trust for your benefit. With an IRA, the ownership resides with you.
Indeed, IRA assets are your property and you can direct your IRA custodian to maneuver your assets as you wish.
Typically, all that’s required is your signature to authorize a change in investments, or to make an account withdrawal or rollover.
Because your employer sponsors the 401k plan, the assets are not actually your property, but instead are owned by the plan. Federal law requires that your contributions be held in a trust and administered by a trustee, who is charged with managing the assets on your behalf.
The trust holds your 401k money apart from your employer’s general assets. That means, for example, that your employer can’t use them as collateral for a business loan and the money can’t be seized by creditors if your employer goes bankrupt
The drawback to these protections is that there has to be an additional level of administrative oversight. That’s why 401k money is tougher to get than IRA money.
401k Rollover Defined
From the IRS’s perspective, a 401k rollover occurs when you withdraw cash or other assets such as stocks, bonds, and mutual fund shares from one qualified employer’s 401k plan and contribute all or part of it into another 401k plan, a qualified retirement plan, or a traditional IRA within 60 days. This is sometimes known as the 60-day rollover rule. Generally, if you have not reached the magic age of 59 1/2, then contributions you made to your 401k plan on a before-tax basis are eligible for rollover.
This is a pretty important process to follow because the tax penalties are quite unattractive. In the next several sections we will explain a simple process that you should follow and the “be careful” process that you could be involved in with a 401k rollover.
Direct 401k Rollovers (Trustee to Trustee Transfer)
In a direct 401k rollover scenario, your previous qualifying 401k plan administrator will usually require you to fill out several forms describing the amounts withdrawn, and the account information for the new 401k plan, qualifying plan, or the IRA into which the retirement funds will be deposited.
Direct 401k rollovers are the most convenient way to move money from your existing 401k plan into another retirement account. With a direct 401k rollover, the money is transferred from one financial institution to another and you should never have to worry about withholding rules or tax penalties. Unless you need to take possession of the 401k funds in your account for some reason, a direct 401k rollover is really the safest and easiest way to make a transfer.
401k Rollover Payments to Individuals
If you have not reached age 59 1/2 and you chose to have the money in your 401k plan paid directly to you, then it is important that you be aware of immediate tax penalties that kick-in and withhold requirements you’ll encounter. With a 401k rollover that is paid to an individual, there is a mandatory 20% withholding even if you intend to deposit, or roll over, the money into a new retirement plan later on.
When you’re doing this kind of 401k rollover, you will have to add funds from other sources to offset the 20% withheld. If you do not add these funds, then you may be subject to an early withdrawal tax penalty.
Table 1 – Comparison of taxes on 401K rollover types.
| Affected Item |
Rollover Payments to Individual |
Rollover Payments to Individual Direct Rollover (trustee to trustee transfer) |
| Withholding |
The plan must withhold 20% of the
taxable distribution
|
There is no withholding |
| Additional Tax |
If you are under 59 ½, a 10%
additional tax may apply to the
taxable part (including an amount
equal to the tax withheld) that is not
rolled over
|
There is no 10% additional tax |
| When to report as income |
Any taxable part (including the
taxable part of any amount withheld) not rolled over is income to you in the year paid
|
Any taxable part is not income to you until later distributed to you from the IRA |
Source: IRS Publication 590
401k Taxable Distributions
If you under age 59 1/2 at the time of what is now deemed a 401k distribution, and you are not able to follow this process, the tax penalties will immediately start to take hold. There are two “penalties” that occur if your rollover becomes a distribution:
• You will have to treat any funds not deposited / rolled over as income for that tax year.
• You will be assessed a 10% early withdrawal penalty on the 401k funds not deposited.
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