To execute a proper direct rollover of your 401 plan balance, or any funds from your employer sponsored retirement plan,  into an IRA, is a simple matter unless you make the big tax mistake explained below.

Direct Rollover
When you distribute money from your 401 plan to an IRA, this is typically a non-taxable distribution.   These distributions usually occur when you change jobs or at retirement or if your employer dissolves the company sponsored plan. The way to insure this IRA Rollover is non-taxable is to do a direct rollover, also known as a direct transfer or as a trustee to trustee transfer.

For example, let’s say you have money in a employer-sponsored plan, such as a 401k.  You leave the company because you retire or change jobs and desire to roll over your account to your own traditional IRA account.  Your desire is to invest your funds in a more liberal way as you have more choices in your own IRA account. Your employer will provide a form for you to transfer your retirement money to your new financial institution.  When you complete the form it is essential that you tell your employer to send a check DIRECTLY to the new custodian (the bank or brokerage firm that acts as custodian for your IRA account).   Do NOT have the employer send the check to you or payable to you as this requires that 20% of the account value be withheld for federal income tax and you have created a nightmare in order to complete your IRA roll over on a tax free basis.

The Indirect Rollover-Avoid It
If the check comes from your employer payable to you (rather than being sent to your IRA custodian) you have created the following pr0blem.  You had a check sent payable to you and 20% was withheld (your employer is required by IRS to do so if the check is paid to you).  You had $100,000 in the retirement plan and after the withheld tax, you now have retirement funds of $80,000 in your hands.   If you deposit the $80,000 into an IRA rollover within 60 days of receiving the check, then you will have completed a tax free rollover for $80,000 but you will owe federal and state income tax on the remaining $20,000.  You may complain that it’s impossible to roll over the other $20,000 as your employer kept it (actually, they withheld it and sent it to IRS for your current year’s estimated tax).   IRS does not care about your complaint–you made a mistake in instructing your employer how to handle the check and it’s now your tax problem.

If you don’t have $20,000 of your own funds that you can add to the $80,000 and complete a 60 day rollover of the entire $100,000, you will owe tax on the $20,000 you do not rollover (about $6,000 tax on average).  Note that next April 15, you have already paid $20,000 toward your federal taxes (the money your employer withheld) and you may get a nice refund.

There may be an incidence when you want to pay the tax in your IRA rollover  because the tax now will be less than the tax later.  For example, you may want to roll over your 401k balance to a Roth IRA Rollover account.  The great feature of the Roth IRA is that the money grows tax free and is distributed tax free to you or your heirs.   However, in the year that you roll over funds to a Roth IRA, you must pay income tax as if you had distributed the funds.  This could be a smart tax strategy in the following case.

Let’s say you left your job in January and had earned $8,000.  You did not work the rest of the year and had no other earnings.   The 2010 tax tables show that a single individual can have taxable income up to $34,000 and pay 15% (top rate) in federal taxes.  Given that you think tax rates in the US can only go up, you take $26,000 from your 401k account and roll over to a Roth IRA.  (This $26,000 is added to your $8,000 income for a total income of $34,000 keeping you your total federal tax bite under 15% in this simplified example).  You are happy to pay this low IRA income tax today rather than a 40% tax rate you project for yourself in the future.  For the remainder of your 401k balance ($74,000),  you do an IRA rollover to a traditional IRA on a tax free basis.  Of course, the money in the traditional IRA will eventually be taxed when you withdraw it.

Learn more.  Get your free copy “Six Best and Worst IRA Rollover Decisions“