IRA Rollovers: How to Avoid Mandatory Withholding

Here's how to create a rollover IRA the easy way

401(k)
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One of the most important features of any successful retirement plan is keeping all your money working for you. Unfortunately, a shockingly high rate of people fail to roll over their 401K and 403B plans when they stop working for a specific employer—they don't properly execute a rollover IRA.

Leaving your plan money behind at your employer is an acceptable choice, that’s not what typically occurs. The money, which had been earmarked for retirement, is often cashed out instead. This retirement plan distribution is usually subject to federal taxes, state taxes, and an early distribution penalty as a result. You'll also lose future growth on the money you take out.

Key Takeaways

  • An IRA rollover is a relatively simple process where the full amount of your qualified plan balance is effectively transferred to an Individual Retirement Account (IRA).
  • Your distribution will be subject to a mandatory 20% withholding tax if you don't properly request a rollover.
  • Be sure to check with your retirement plan sponsor and IRA custodian before choosing to take an IRA rollover.
  • Other options exist, such as staying in your old employer's retirement plan, completing a rollover to your new employer's plan, or taking a cash distribution.

An IRA Rollover Is Often the Smart Way to Go

An IRA rollover is a relatively simple process where the full amount of your qualified plan balance is effectively transferred to an Individual Retirement Account (IRA). Your distribution will be subject to a mandatory 20% withholding tax, however, if you don't properly request a rollover.

You still have 60 days to deposit the full amount of your original 401K account value and avoid a taxable distribution. If you had the money inadvertently withheld, however, you have to come up with the amount withheld to complete the rollover. It's obviously far better to do things the right way the first time.

Here are a few potential benefits of completing an IRA rollover:

  • An IRA rollover allows you to avoid the 10% early withdrawal penalty if you're under age 59½.
  • Your money will continue to grow for retirement and you'll be able to defer taxes until you withdraw the funds later on in retirement.
  • You might be able to find a wider array of investment choices than those available in your employer's plan, providing you with the potential to improve your overall diversification.

Examples of the Impact of Mandatory Withholding and IRA Rollovers

Example 1

Derrick quits his job with a $50,000 401K plan balance. He doesn’t intend to roll over his account and decides to take a distribution at that time. He'll receive a check for $40,000, because 20% ($10,000) must be withheld. If Derrick reconsiders and subsequently decides within 60 days to roll over his entire 401K plan balance, he can still do so. He has to come up with the original $10,000 temporarily lost via withholding, however. He won’t be able to get the withheld funds back until he files his tax return next year.

Example 2

Consider the following in the same scenario above. If Derrick had just properly requested a rollover from the start, he would have received a check made out to his IRA custodian for the benefit of his IRA for the full $50,000.

Example 3

The 20% already lost to tax withholding might be a drop in the bucket compared to what he'll eventually owe if Derrick doesn’t roll over the account and takes the full distribution. Not only will he pay his top marginal tax rate on the distribution (which could be higher than 20%), but he might also be subject to a 10% early distribution penalty if he's younger than age 59½, and possibly state income taxes, too.

Example 4

This time Derrick just rolls over the $40,000 he has remaining after the mandatory withholding. He will be subject to taxes and the 10% penalty on the $10,000 not distributed. That's better than a total distribution to be sure, but it's still worse than a successful rollover of the entire balance.

Summary

An IRA rollover is a retirement savings vehicle that's tax-deferred and receives funds from an employer-sponsored retirement plan such as a 401(k) plan. You have the option to roll over your retirement account if you retire, change jobs, or leave your employer for any other reason.

Just be sure to check with your retirement plan sponsor and IRA custodian before choosing to take an IRA rollover. As with most financial transactions, certain restrictions, limitations, or fees might apply. An IRA rollover isn't always the best decision. Other options exist, such as staying in your old employer's retirement plan, completing a rollover to your new employer's plan, or taking a cash distribution.

Updated by Scott Spann.