What is a 401k Rollover? - 20% Withholding Tax, IRA Rollovers, Divorce Proceedings

(March 3rd, 2008)

There are high chances that you will rollover your 401k retirement plan atleast once in your lifetime, if not multiple times. A 401k rollover is usually done when an employee leaves his current employer and moves to another company. The administration of the employee's 401k account will be moved from old employer to new employer. A 401k rollover can also be done when a participant is eligible to rollover his current traditional IRA into a Roth IRA or Roth 401k. We will explain how to do these 401k rollovers right in this next section.

Changing Employers & Avoiding the 20% Withholding Tax

If you are leaving your existing job, that would be a great time to rollover your traditional 401k plan into an IRA. This option is even better than rolling over to your new employer's 401k plan. Why? Because your investment options are unlimited. In a 401k plan, your investment is limited to the mutual funds & stocks that your employer invests in. However when you rollover into your own IRA, you can invest in stocks, bonds, commodities & other higher yielding assets.

When you leave your current employer, they will send you a check for your fully vested 401k retirement savings that you have accumulated. This is treated as a cash out transaction and your employer will be required to withhold a 20% tax amount, leaving you with only 80% of your cash. This is NOT what you want to do! Furthermore, you will be required to pay a 10% early withdrawal penalty if you are under the age of 55 and withdraw your 401k retirement savings as cash.

To avoid this cash out transaction, you must arrange for a Direct 401k rollover. Also known as a trustee to trustee 401k rollover, this rollover will instruct your old employer to make out a check in the name of your new 401k plan manager or "custodian" as they call it. This way, you will not be getting any cash. Your 401k funds will be sent to your new 401k custodian. Ask your new 401k custodian exactly how they want to receive this payment. Usually it will be like "Investment Banking Corporation, for the benefit of Peter James..."

The next step after this will be to inform your former employer's retirement plan admin that you are making a direct rollover of your funds to your new account. The admin will ask how you want this check to be styled & printed. As soon as you receive the check, you should deposit it into your new IRA. There is a 60 day limit within which you must deposit this check to your new IRA or 401k, otherwise you will be charged tax on it, as well as a 10% early withdrawal penalty.

To meet the 60 day rule, count the day you receive the check and include the day when you deposit the money into your IRA. For example if you get the check on April 1st, 2008, you must have it deposited by May 30th, 2008. There is no extension granted for holidays and weekends.

You Must Rollover to Another IRA or 401k

If you take out cash from a 401k or IRA, you must rollover the cash to another IRA or 401k and not another asset of equal value. For example, you cannot take out cash from your IRA, buy some shares on the Nasdaq and then rollover those shares to your IRA, it has got to be a cash to cash rollover transaction. If you do buy shares, you will not be permitted to have a 401k rollover and will be taxed on that liquidated amount + 10% early withdrawal penalty if you are under the age of 55.

If you really do want to buy some shares with that cash, here's what we suggest you do. Rollover the cash to your IRA first and complete the transaction. Then after a few days, purchase the shares you want to invest in. What's even more interesting is that if you rollover stocks from one IRA or 401k to another, you are permitted to do so and will not be taxed. Thus, the rollover either has to be cash to cash, or stock to stock. It cannot be a mix of cash to stocks or stocks to cash.

Using an IRA Rollover as a Short Term Cash Source

YOu may be short of cash one month and urgently need cash. You can either go borrow a payday loan, or you could borrow from your IRA temporarily and pay it back. This is known as a tax free IRA rollover and includes no interest charges, hassle of dealing with loan officers and no paperwork. You must however pay back the entire cash amount within 60 days. If you don't, you will be considered to have made a taxable IRA withdrawal and will owe 10% penalty for the premature withdrawal.

IRA Rollovers in Case of Divorce

If you are undergoing a divorce, you can distribute all or a portion of your IRA assets to your ex-spouse's IRA account. This is common when divorces happen as part of the split up of assets. This is tax-free if you follow these steps:

i) The split of your IRA assets must be pursuant to the terms of your divorce settlement

ii) The split-up of funds must be finished by you rolling over your IRA funds into an IRA account set up by your spouse. This will then be considered your spouse's IRA rollover and any withdrawals made by your spouse will result in him/her owing taxes.

Any other type of transaction apart from the above will be treated as a taxable IRA withdrawal and your spouse will owe taxes immediately. This is even if the transaction happens before/after the divorce. Furthermore if you are under 59 and 1/2 years of age at that time, you will owe an additional 10% early withdrawal penalty payable to the IRS. As explained above, do not try to take out a cash withdrawal from your IRA and give it to your spouse to fulfill your financial commitments or to be nice, this will cost you!

Be sure that your divorce settlement says that any or all transfers of your IRA funds to your ex-spouse will be pursuant to the divorce settlement and intended to be tax-free under the Section 408(d)(6) of the Internal Revenue Code. Also be sure that you do a trustee-to-trustee or direct rollover from your IRA account directly in to your spouse's IRA account, and inform your previous IRA administrator of doing so. What's fair about this deal is that if the other party withdraws money from their IRA account, they will owe the income taxes and not you!