As some people progress through their careers and change companies from time to time, they may find that they have multiple 401(k) plans or other retirement accounts. If you decide you don’t want to work with multiple plans, you can carry over your old plans to your new plan, making it much easier to manage and update.
If you’re considering a rollover, there are three things you should know beforehand.
1. The type of rollover you want
With a rollover, you can choose between a direct rollover and an indirect rollover. With a direct rollover, your previous plan provider sends your money directly to your new plan provider without you ever touching it. If a plan-to-plan transfer cannot be made directly, in some cases your old plan provider will write a check in the name of your new plan provider, but will give it to you to deposit into the new account. Although you owned the money, it wasn’t in your name, so it’s still considered a direct rollover.
In an indirect rollover, your old plan sends you the money and you are responsible for getting it to your new account. The IRS gives you a 60-day grace period to put the money into your new plan or put it back into your old account. In most cases, it’s easier to roll over directly, but there may be times when it’s beneficial to be able to access your funds in between switching accounts.
2. Money can be withheld
When you perform an indirect rollover, your legacy plan provider typically withholds 20% of the total amount for tax purposes. So if you go over $100,000, you technically only get $80,000. You are also responsible for making up the withheld amount if you move your money into your plan.
In this scenario, if you roll back the $20,000 and repay the entire $100,000, you owe no taxes and receive the $20,000 withheld as a tax refund when you file your tax return for the year. If you deposit everything but the withheld $20,000, you will owe tax on that amount and potentially face a 10% early withdrawal penalty. If no money is deposited within the 60-day window, the entire $100,000 is counted as taxable income and the $20,000 withheld is counted as taxes paid.
3. You may be able to trigger a tax bill with a Roth conversion
Retirement accounts such as a 401(k) or traditional IRA are pre-tax accounts. With a 401(k), the money is deducted from your account before you even get your paycheck. Contributions to a traditional IRA are technically post-tax, but you may be able to deduct your contributions so that they are marked before tax since your tax benefit is on the front end. On the other hand, a Roth IRA is an after-tax account; You make after-tax contributions and receive your tax benefit at the end.
If you transfer money from a 401(k) or traditional IRA to a Roth IRA, you will likely owe taxes on the amount transferred. Usually, no tax has been paid on the money in your 401(k). When you turn that money into a Roth, the IRS takes that opportunity to get their share.