What you need to know before you roll over your 401(k) – The difference between a rollover and transfer

A 401(k) plan can be funded through several avenues including contributions, a transfer, and a rollover. In this article, we will discuss the key differences between a rollover and a transfer along with the key steps required to avoid costly penalties and unfavorable tax consequences.

There are several reasons an individual would choose to move retirement funds from one plan or provider to another plan or provider. A change in jobs or retirement is a common reason for initiating a rollover or transfer. Another potential reason to move funds is a scenario where an alternative financial institution is discovered which offers an expanded list of investment options at a lower cost. Regardless of the underlying reason, it is important to understand the key distinctions of a rollover versus a transfer to complete the process properly and avoid unnecessary penalties and taxes.

Understanding a transfer

A transfer is utilized when retirement funds are moved from one firm to another firm with the retirement plan type unchanged. If an investor holds a traditional IRA with one firm and decides to move this account into a traditional IRA with another firm, this would be classified as a transfer. To qualify as a transfer, there must be a direct movement and the account type must remain the same. Transfers do not need to be reported to the IRS, as the account owner does not receive a distribution in this scenario. There is no limit to the number of times a transfer can be completed within a twelve-month period.

401(k) Rollover

A rollover occurs when an individual transfers retirement funds from one type of retirement account to a different retirement account type. One common scenario where this occurs is a rollover from an employer sponsored plan to an IRA. A benefit of completing a rollover is to maintain retirement assets in the same tax-sheltered status which allows the funds to continue to grow on a tax deferred basis. An individual completing a rollover may also find that they now have a higher number of investment options available with the new provider, potentially at a lower cost. A 401(k) rollover can be classified as either a direct or indirect rollover.

Direct Rollover

A direct rollover occurs when retirement assets are transferred directly from one provider to another. Under a direct rollover, the individual does not receive the funds and instead they are sent directly to the provider where the new account was established. This may sound similar to a transfer, however the key difference is that the retirement plan type in the new account is different from that of the initial account. Another differentiating factor between a transfer and direct rollover is that the IRS is notified when a direct rollover occurs. Although it is reported to the IRS, no tax will be withheld or owed if the direct rollover is completed properly because no distributions are being provided to the account owner. There is no limit to the number of Direct Rollovers that can occur in a given year.

Indirect Rollover

An indirect rollover occurs when funds in a retirement account are provided directly to the account owner. The account owner then has a 60-day window to deposit these funds into a qualified IRA in order to avoid costly penalties and taxes. For this reason, an indirect rollover is commonly referred to as a “60-day rollover”. There are certain exceptions which allow the 60-day rule to be waived, including a situation where the 60-day window was missed solely due to an error on the part of the financial institution, however generally the 60-day window must be adhered to. The IRS permits one indirect rollover from the same retirement account within a twelve-month period.

Rules & Limitations

There are specific exceptions, rules, and restrictions that account owners should be aware of as a transfer or rollover is completed. Required minimum distributions cannot be included in the amount which is rolled over from the initial retirement account to the new account. Generally, an individual is required to begin taking distributions from a retirement account beginning at age 70 ½. However, if your 70th birthday falls on July 1st 2019 or later, the required minimum distribution age is 72. Roth IRAs do not require minimum distributions until the death of the owner. For more information on this, the IRS provides a “Uniform Lifetime Table” which is helpful in understanding and calculating required minimum distribution amounts.

In addition to required minimum distributions, there are several other forms of distributions or withdrawals which are not eligible to be rolled over into the new retirement account. These include loans treated as distributions, hardship distributions, distributions of excess earnings and related earnings, a distribution which is part of a series of substantially equal payments, withdrawals electing out of automatic contribution arrangements, distributions to pay for accident or health/life insurance, dividends on employer securities, or S corporation allocations treated as deemed distributions.

Mandatory Withholding & Penalties

When funds are provided to an account owner from a retirement plan as part of an indirect rollover, a mandatory tax withholding of 20% occurs. This withholding takes place even if the account owner plans to roll the funds over to another qualified plan within the required 60-day timeframe. In this scenario, an account owner can utilize other sources of funds to make up for this withholding to roll over the full balance into the new retirement account. As an example, if an account owner requests an indirect rollover of $100k, the account owner would receive a check for $80k and the remaining $20k would be withheld for taxes. The account owner could then utilize another source of funds, such as a savings or brokerage account, to replenish this amount to $100k to be deposited into the new retirement account. If the indirect rollover is completed properly and meets requirements, the account owner would receive a refund of the $20k tax withholding when taxes are filed. If instead the account owner elects to only roll over the $80k amount, then the remaining $20k will be reported as taxable income for that year. If the individual is younger than 59 ½ years old, then an additional early withdrawal penalty of 10% on top of ordinary income tax would be owed.

The Bottom Line

Depending on an individual’s specific circumstances and investment strategy, rolling over or transferring a 401(k) can be a great option. Understanding the difference between a transfer, direct rollover, and indirect rollover along with applicable taxes and penalties can help account owners minimize fees and maximize long-term savings. It is always advisable for someone considering these options to discuss their individual situation in greater detail with a Financial Advisor and Tax Professional.