Tax Consequence of Rolling Over a 401(k) to an IRA

by Mark Kennan

When you leave your job, you may consider rolling over your retirement money from your 401(k) plan to a traditional or Roth IRA. As you make your decision, you need to consider the tax implications and filing requirements of both types of rollovers. With a rollover, you receive the money and have up to 60 days to put it into another qualified account.

Taxes On Rollovers

When you roll money from a 401(k) plan to a traditional IRA, you do not incur any additional income-tax liability because you moved the money from one tax-deferred retirement plan to another tax-deferred retirement plan. If you roll the money into a Roth IRA, you move the money into an after-tax account which requires you pay income taxes on the conversion. The advantage to rolling over the money to a Roth IRA is that you can take tax-free qualified distributions.

Tax Withholding

Even if you roll over money from a 401(k) plan to a traditional IRA, your financial institution will still withhold money for income taxes and penalties you will owe if you do not complete your rollover. When you report the rollover on your income taxes, remember to report the amount withheld as part of your federal income taxes withheld. To avoid the withholding, you can instead perform a transfer, which has the same effect of a rollover, except instead of the money being paid to you, it goes directly from the 401(k) plan to the IRA.

Tax Reporting for Rollovers

Even if you do not incur additional income-tax liability, the IRS requires you to report your 401(k)-to-IRA rollover on your income taxes. Report the total amount of the rollover as a nontaxable pension and annuity distribution. Enter "0" as the taxable amount of the distribution and write "rollover" next to "0" if you rolled the money into a traditional IRA. If you rolled the 401(k) into a Roth IRA, enter the total amount of the distribution as a nontaxable distribution, then complete Form 8606 to calculate the taxable amount of the rollover.

Company Stock Exception

If your 401(k) plan holds a portion of the account in company stock and you take the stock out of the account as part of a lump-sum distribution, you may be better off withdrawing the stock rather than rolling it into your IRA. When you sell the stock, you pay income taxes on the price paid for the stock and only capital-gains taxes on the earnings as long as you hold the stock for at least 12 months. The capital-gains tax is lower than the higher income-tax brackets. You can roll over the remaining assets in your 401(k) plan to an IRA.

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