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By Jenn Pavlick
Updated on November 29, 2023
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When you change jobs, you may want to move your retirement funds from your previous employer’s 401(k) plan. This can be completed through a rollover, which transfers the funds to your new employer’s plan or to another tax-deferred retirement account like a Traditional IRA.
There are two ways of completing this transfer: a direct rollover or an indirect rollover. With a direct rollover, your previous 401(k) plan administrator sends your funds directly to your new retirement plan without you ever having access to the money, thereby avoiding income tax and the potential for early withdrawal penalties.
With an indirect rollover, the transfer works a bit differently. With an indirect rollover, funds are distributed directly to you. You’re responsible for reinvesting them into a new retirement account within 60 days to avoid income tax and early distribution fees. Most financial institutions and advisors recommend a direct rollover because the indirect option can be risky — and potentially quite costly.
So why would someone choose this option? You may choose an indirect rollover when you’re looking for a short-term loan that matches the distribution amount and are sure you can re-deposit the total amount (or the entire original 401(k) balance, before tax withholding) within 60 days.
The 60-day rollover rule states that when you withdraw funds from your retirement account, you must redeposit the full amount within 60 days to avoid an early withdrawal penalty or income taxes. The money can be redeposited into an Individual Retirement Account (IRA), like a traditional IRA, an employer-based SIMPLE IRA, or a new QRP like a 401(k).
This rule applies to indirect rollovers, and there are severe penalties if you fail to re-deposit the full amount in time:
When you initiate an indirect rollover, the plan administrator must withhold 20% for taxes before they write you a check.
For example, if you have $10,000 in a 401(k) and choose an indirect rollover, your plan administrator will write you a check for $8,000 as the rollover distribution, and you’ll receive those funds into your bank account.
But remember: you’re responsible for redepositing the 401(k)’s entire amount before taxes — not just the amount deposited into your bank account.
This means you must re-deposit the full $10,000 into a new retirement account within a 60-day window, not just the after-tax amount of $8,000. If you don’t, the entire $10,000 will be considered a 401(k) or IRA distribution and will be subject to income taxes and an early withdrawal penalty.
The potential for income tax and tax penalties is why financial advisors and tax advisors recommend the direct rollover option rather than the indirect rollover.
With direct rollovers, you don’t have to worry about income tax, early distribution penalties, or the 60-day window since the money never enters your hands.
Therefore, you may only want to use indirect rollovers in urgent situations like the following:
If you choose this option, be extra mindful of the 60-day transfer deadline, as it’s very easy to miss. If you do, you’ll be stuck with an additional income tax bill plus a 10% penalty on the entire rollover amount.
In addition to the 60-day rollover rule, indirect rollovers are subject to the IRS’s one-rollover-per-year rule. This regulation limits you to one indirect rollover per 12-month period (not just per tax year).
The transfer also must be executed from one account to another. It cannot be split among multiple accounts, or else you’ll be subject to income tax and early distribution penalties on the entire amount.
The 60-day rollover rule doesn’t apply to rollovers in certain situations, including those from traditional to Roth IRAs (called Roth Conversions), trustee-to-trustee transfers, or direct rollovers between QRPs.
A 60-day rollover is another name for an indirect rollover. With this type of transfer, your retirement plan administrator writes you a check, which you receive directly into your bank account. You must re-deposit the funds into another tax-advantaged retirement savings account (like an IRA) within 60 days to avoid taxes and penalties. You’re limited to one indirect rollover per 12-month period.
With a direct rollover, the transfer is executed straight between the two retirement account administrators. The money never enters your hands as the account holder, so you aren’t subject to any taxes or penalties, provided you are rolling money over between accounts of the same tax status. You aren’t limited in the number of direct rollovers you can execute annually.
There is the potential for tax consequences if you choose to complete an indirect rollover of your qualified retirement plan, like a 401(k), to a traditional IRA. When the plan administrator writes you a check for your withdrawal, they hold back 20% as income tax withholding if the funds are tax-deferred (this may not be the case with a Roth 401(k) since you’ll already have already paid taxes on the funds).
As long as you reinvest the full amount of your original 401(k) plan balance (not just the 80% you received) within 60 days, you’ll get the original 20% back when you file your federal income taxes. If you fail to meet the requirements of the 60-day rule, your withdrawal is considered income and will be subject to income taxes.
To avoid potential income tax or early withdrawal penalties resulting from your rollover, you might choose a direct IRA transfer. In this case, the funds are moved from one account to another without entering your hands as the account holder. The plan administrator directly transfers or writes a check to the new account and moves the funds.
With a direct rollover, you don’t have to worry about the 60-day rule, early distribution penalties, or other fees since it’s not considered a withdrawal — so long as you move the money between accounts of the same tax status. For instance, no taxes or penalties apply if you directly roll a tax-deferred 401(k) into a traditional IRA.
Rolling over your 401(k) or IRA is a smart financial decision that can help you keep better track of your investments. It can also help you optimize your retirement savings strategy by reducing fees and helping you access more diverse investment choices, like ETFs and single stocks.
But as we mentioned, most investment advisors, personal finance specialists, and tax advisors will recommend a direct rollover instead of an indirect rollover to avoid the risks of income tax and/or early withdrawal penalties.
Whether you choose an indirect or direct rollover, the transfer process can feel complex. It’s usually a good idea to work with a trusted partner who can help you manage your rollover.
Capitalize can streamline the process and contact your plan administrators, help you avoid fees, and follow all regulations along the way. We can also help you find your previous 401(k)s and move them into the right spot.
Get started with us today to learn more!
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