IRA Financial Blog

401(k) Rollovers & Possible Tax Consequences

November 14, 2023

One of the major differences between an IRA and a 401(k) plan, from the perspective of the individual retirement account holder, is that an IRA owner can take a distribution at any time, whereas a 401(k)-plan participant is limited. Under certain circumstances, a 401(k) rollover can be performed. Are there any tax consequences that you should be aware of? It depends on the situation. This article will discuss situations that allow you to rollover your 401(k) plan to a new IRA provider and the potential tax consequences of failing to follow the plan triggering event rule.

Key Points

To perform a 401(k) rollover, first, you must satisfy a plan triggering event
401(k) funds can be rolled over to another retirement plan once this happens
Depending on how you roll over the funds, there may be tax consequences you should be aware of

401(k) Plan Triggering Event Requirement & Rollovers

In general, for a 401(k) plan participant to transfer his or her 401(k) funds to an IRA or another retirement plan, a plan-triggering event would need to be satisfied. It is hard for many 401(k) plan participants to believe that they do not have control over their current employer plan funds. The following are the most common triggering events:

Reach the age of 59 1/2
Leave your job
Plan is terminated
Rolled funds into 401(k) plan
Hardship distribution

In sum, if a 401(k) plan participant is under the age of 59 1/2 and continues to be employed by the employer that sponsored the 401(k) plan, the individual will likely not be able to perform a rollover.

401(k) Plan Rollover to a Traditional IRA

If a plan participant satisfies a plan triggering event, the individual will have the ability to rollover funds to an IRA tax-free. A direct rollover means the funds are transferred directly from the 401(k) plan to an IRA. A direct rollover can be done in cash or in-kind, by rolling over the asset directly, such as stock or real estate.

A direct rollover to an IRA is not subject to any withholding tax. However, once every twelve months, a 401(k) plan participant who can satisfy a plan-triggering event, may engage in an indirect rollover.

Unlike a direct rollover, with an indirect rollover, the funds are transferred from the 401(k) plan to the retirement account owner, who will have sixty days to use the funds for any purpose without tax or penalty. The funds must then be rolled into an IRA or another retirement plan within that period. If the retirement account holder misses the deadline, the entire amount of the indirect rollover will be deemed subject to tax, and a 10% penalty if the individual is under the age of 59 1/2.

One thing to consider, in the case of an indirect rollover, a 20% withholding tax would apply even if you intended to roll it over later to another retirement plan. If you do roll it over and want to defer tax on the entire taxable portion, you’ll have to add funds from other sources equal to the amount withheld. Note – the 20% withholding tax does not apply to direct rollovers.

401(k) Plan Rollover to a Roth IRA

A 401(k) plan participant that has satisfied a triggering event can rollover funds to a Roth IRA. There are two scenarios in which this can occur.

First, a 401(k) plan participant that has pretax funds can elect to roll the funds to a traditional IRA, and then convert the Traditional IRA to a Roth. A conversion is subject to income tax on the fair market value of the assets converted.

Secondly, a plan participant who has Roth 401(k) funds can rollover those funds tax-free to a Roth IRA. The rollover can be direct or indirect. However, an indirect Roth IRA rollover can only be done once every 12 months and is subject to the aforementioned sixty-day rule.

Conclusion

The most common way to move funds from a 401(k) plan to an IRA or Roth IRA is via a direct rollover. Almost $500 billion each year is rolled over from 401(k) plans to IRAs. For those with pretax 401(k) funds that want to do a direct rollover to a Roth IRA, the rollover must first technically go to a traditional IRA and then can be converted to a Roth. Most companies, such as IRA Financial, will only charge for the Roth IRA, in the case of a conversion scenario.

There are two instances where you should be aware of tax consequences. The Roth conversion, and the indirect rollover route. You should plan accordingly before moving your funds from one plan to another.