What is a 401(k) rollover?
A rollover occurs when a plan participant takes a distribution of cash or other assets from a 401(k) plan and then contributes it to another qualifying plan, IRA or 401(k) within 60 days. Rollovers can be direct trustee-to-trustee transfers, or indirect, with the distribution paid to the account owner.
Not all of the money in a 401(k) may qualify for rollover. Distributions that are part of a series of regular payments, required minimum distributions (RMD), hardship withdrawals, dividends paid on employer securities and the cost of life insurance coverage are not eligible for rollover. Defaulted 401(k) loans and corrective distributions may be eligible under certain circumstances. After-tax contributions can only be rolled into an IRA or a retirement plan that keeps track of the taxable and nontaxable parts. An indirect rollover distribution is subject to federal income tax withholding of 20%. To avoid paying any income tax, funds equal to the amount withheld have to be used.
Under the direct rollover option, there is no mandatory withholding. For example, you request a full distribution from your 401(k), which has a balance of $55,000. Using a direct distribution, $55,000 transfers from one account to another. If the payment is made to you, $11,000 is withheld for federal taxes and you receive a check for $44,000. For this distribution to be completely tax deferred, you must deposit the $44,000 from the 401(k) and $11,000 from another source into a qualifying plan within 60 days.
Reasons to roll over 401(k) funds can include changing jobs and preferring to participate in the new employer's 401(k), dissatisfaction with the current plan management and using an indirect rollover as a no-interest short-term loan.
All 401(k) distributions have a Form 1099-R issued and must be reported on the recipient's tax return. Any taxable amount that is not rolled over must be included as income. A 10% early withdrawal penalty may apply if the plan participant is under the age of 59.5 at the time of the distribution. There are exceptions to this penalty, which can be found in the instructions for Form 5329.