Tax Treatment of Rolling Over Your 401(k) to an IRA

by Leslie McClintock

When you leave your job, you generally have a choice about what to do with your 401k balance. You can cash it out, you can leave it in place (if the plan allows), or you can roll it over into another tax-deferred retirement plan, such as an individual retirement account (IRA) or a 401k plan. If you are considering a rollover, it's important to do it correctly to minimize taxes and penalties.

General Rule for Withdrawals

It's important to understand the taxes and penalties you may incur if you don't execute a rollover properly or choose to cash out: You will have to pay income taxes on the entire amount of the 401k withdrawal, unless it's a Roth 401k. If you are under age 59 1/2, you will also have to pay a 10 percent penalty on the entire amount of the withdrawal. If you personally receive the funds, you have only 60 days to complete the rollover. If you do not complete a rollover in that time, the Internal Revenue Service will deem you to have taken a distribution, and you will pay state income taxes, federal income taxes and a 10 percent penalty on the whole amount.

Withholding Requirement

If your 401k plan distributes the balance -- or any part of it -- directly to you, they must withhold 20 percent of the plan to pay income taxes. Your ultimate income tax bill at the end of the year will be reduced by this same amount. You get credit for it, but the 10 percent penalty applies to the entire amount withdrawn, including the 10 percent penalty.

Trustee to Trustee Transfers

To avoid the 20 percent withholding requirement, and the risk that you will fail to complete a rollover in 60 days, you may want to consider a trustee-to-trustee transfer. This means you set up an IRA account with an investment company, and then direct your 401k trustee to transfer funds directly to the plan.

Tax Consequences of Rollovers

Generally, there is no tax consequence to a properly executed rollover. Because the 401k plan and the IRA are tax-deferred investment vehicles, there is no capital gains or income tax due on the transaction. If you want to roll the balance over to a Roth IRA, however, you will need to pay income taxes on the amount you move to the Roth IRA. You will not need to pay a 10 percent penalty, however, nor will you need to pay taxes on this money in retirement, provided the money has stayed in the Roth IRA for at least five years.

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