Rollovers: Direct vs. Indirect, and the 20% Withholding Trap
Moving money from an employer plan to an IRA should be simple. Taking the check yourself instead of a direct rollover can trigger mandatory withholding, a 60-day deadline, and taxes. Here is the math.
When you leave a job, you can usually move your 401(k) or similar plan balance to an IRA or a new employer's plan. How you move it matters a lot.
Direct vs. indirect
- Direct rollover: the plan sends the money straight to the IRA or new plan. No taxes are withheld, and there's no deadline to meet.
- Indirect rollover: the plan pays you, and you deposit the money into an IRA or plan within 60 days. Plans generally must withhold 20% for federal taxes on eligible distributions paid to you.
The withholding trap, in numbers
A hypothetical $100,000 401(k) balance, paid to the participant:
To roll over the full $100,000 within 60 days, you'd need to add $20,000 from other savings. You'd get the withheld $20,000 back as a refund or credit when you file your tax return, if the full amount was rolled over.
If you deposit only the $80,000:
Show the numbers behind this chart
| Tax and penalty owed | |
|---|---|
| Direct rollover | $0 |
| Indirect, $20,000 made up | $0 |
| Indirect, only $80,000 deposited | $6,400 |
A direct rollover avoids the whole problem.
IRA-to-IRA rollovers
Between IRAs, you can generally make only one indirect rollover in any 12-month period, across all your IRAs. Trustee-to-trustee transfers don't count toward that limit and can be done as often as needed. See IRA rules.
Other considerations before rolling over
- Investment choices and fees in the plan vs. an IRA.
- Creditor protection may differ between employer plans and IRAs.
- Age 55 rule: employer plan withdrawals after separating from service in or after the year you turn 55 can avoid the 10% additional tax; rolling to an IRA gives that up. See early withdrawal exceptions.
- Company stock may have special tax treatment to consider before rolling over.
- Outstanding 401(k) loans; see 401(k) loans.
- Backdoor Roth plans: pre-tax IRA balances affect the pro-rata rule.
The takeaway
Ask for a direct rollover. If you take an indirect rollover from an employer plan, 20% is withheld, and you have 60 days to deposit the full amount, including the withheld part, to avoid taxes and possible penalties.
Sources
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