Rolling Over Your 401(k)? Take These 4 Key Steps to Avoid Costly Tax Mistakes
Rolling over funds from employer plans to IRAs requires careful planning. This guide highlights four key steps: confirm eligibility, take RMDs first, check penalty exceptions for those under 59½, and opt for a direct rollover to avoid tax withholding.
According to a 2024 research report, $595 billion was rolled over from employer plans to traditional IRAs in 2020. That report also stated that 62% of US households—or 25 million—with IRAs rolled over amounts from employer plans to traditional IRAs. If you plan to be part of this rollover trend, you must ensure that your rollover does not create unintended tax consequences. Using a rollover checklist can help to avoid mistakes. We provide four items focusing on rollovers from employer plans to traditional IRAs to get started.
Please note:
Examples of employer plans include defined-contribution plans, defined-benefit plans, 403(b) plans, and governmental 457(b) plans. This article does not cover rollovers from designated Roth accounts, such as Roth 401(k)s.
This article focuses on rollovers of pretax amounts from employer plans to traditional IRAs. Rollovers can also be made to Roth IRAs and other employer plans, but the rules and results might differ.
1. Make Sure the Amount Is Eligible to Be Rolled Over
Once a participant meets the eligibility requirements for taking distributions from their employer plan account, they can roll over eligible amounts to IRAs—or other eligible retirement accounts. Amounts not eligible to be rolled over include required minimum distributions, excess contributions, and hardship withdrawals.
Participants must check with their plan administrator to determine how much of their distribution can be rolled over.
If a participant rolls over ineligible amounts to their IRA, it could create an excess contribution. Excess contributions must be corrected by the IRA owner’s tax filing due date, plus extensions, and are subject to additional rules beyond the scope of this issue.
2. Take RMDs Before Rollovers
Generally, retirement account owners must start taking their RMD the year they reach age 73 (age 75 for those born in 1960 and after). If the plan’s terms allow, a participant can defer RMD past 73 until they retire.
Participants must check with their plan administrator to confirm when they must start taking their RMDs.
When an RMD is due, it must be distributed before any rollover. This requirement is because the first distribution made in a year for which an RMD is due includes the RMD until it is satisfied. The following examples demonstrate this rule.
Example of a wrong order for a rollover in an RMD year:
Sally is 73 this year and retiring from working with Widgets and Things. Sally’s RMD for this year is $20,000.
Sally rolls over her entire 401(k) balance except for $20,000, and she plans to take the $20,000 later in the year as her RMD.
This distribution order (rollover before RMD) is not permitted because the first money that leaves Sally’s 401(k) includes her RMD, and RMDs cannot be included in a rollover.
The $20,000 RMD included in Sally’s rollover has created an excess contribution to her IRA. Sally must notify her IRA custodian of the excess and work with them and her tax advisor to make corrections.
Example of a right order for a rollover in an RMD year:
Jake is 80 and retiring from working with Widgets and Things. Jake’s RMD for this year is $20,000.
Jake requests $20,000 to be distributed to him. This $20,000 is Jake’s first distribution made this year and satisfies his RMD.
Jake rolls over the remaining 401(k) balance to his IRA. This order (RMD before rollover) complies with the rollover rules.
3. Under Age 59½? Check For 10% Penalty-Exception Retention
Distributions taken before a plan participant reaches age 59½ (early distribution) are subject to a 10% additional tax unless an exception applies. Some exceptions that apply to employer plans do not apply to IRAs. Therefore, if a participant plans to roll over their 401(k) to their traditional IRA and then take distributions from the IRA, steps should be taken to check to ensure that they will not lose qualification for an exception.
Example 1: 52-year-old Dan is awarded $500,000 of his wife’s 401(k) account under a qualified domestic relations order.
A QDRO distribution is one of the exceptions to the 10% early distribution penalty that applies to employer plans but does not apply to IRAs.
Dan rolled over the $500,000 to his traditional IRA and subsequently took a distribution of $200,000 from his IRA. Dan will not roll over that $200,000 distribution from his IRA and must, therefore, include it in his income for the year.
In addition to any income tax due, Dan will owe the IRS the 10% early distribution penalty of $20,000 unless he qualifies for an exception that applies to IRAs.
Example 2: 44-year-old Susan was awarded 50% of her husband’s 401(k) under a QDRO. She requested a distribution of $50,000 to be paid directly to her.
Susan will owe income tax on the $50,000. However, she will not owe the 10% early distribution penalty because a QDRO is an exception for distributions made from an employer plan to an alternate payee.
4. Choose a Direct Rollover, Not an Indirect Rollover
Participants have two options for rolling over their 401(k) to their IRA: a direct rollover and an indirect rollover.
Under the direct rollover option, the plan administrator will pay the amount to the IRA custodian for credit to the participant’s IRA.
Direct rollovers are not subject to tax withholding. Therefore, if a participant requests a direct rollover of $100,000, their plan administrator will pay their IRA custodian $100,000.
With an indirect rollover, the distribution is paid to the participant, who has 60 days, or later if an exception applies, to roll over the amount to their IRA. The payer will withhold 20% of taxable amounts paid to the participant for federal taxes. For example, if they request a distribution of $100,000 with instructions to pay the amount to them—the participant—the plan administrator will pay the participant $80,000 and pay the $20,000 withheld for taxes to the IRS. This $20,000 would be credited to the participant’s federal taxes paid for the year.
Participants must pay out of pocket the withholding amount if they want to roll over the full amount. Using the example above, the participant would need to use funds from an account that is not an IRA or employer plan account to make up the $20,000 to include in the rollover. They can make up less if they do not have the full $20,000.
Any amount not included in the rollover will be subject to any applicable income tax and the 10% early distribution penalty if they are under age 59½ and do not qualify for an exception.
Ensuring That the Rollover Is Made to the Right Account Is Crucial
A participant and their advisor should discuss and agree on which account is right for a rollover to meet the desired objective. If the goal is to roll over to a traditional IRA, they must ensure that the account set up to receive the amount is a traditional IRA. A rollover from a traditional 401(k) to a traditional IRA is excluded from income. However, a rollover from a traditional 401(k) to a Roth IRA would be included in the participant’s income—thus producing unintended tax results if the intent was to roll over to a traditional IRA.