Most Workers Don’t Realize This 401(k) Move Triggers a Big Tax Bill

Most workers invest in their 401(k) retirement plans on autopilot. Deductions come out of paychecks. Investments are automatic, and workers can check their balance at any time. The tricky part is when workers switch jobs.

The number one mistake workers make when switching jobs is mishandling their 401(k)s. Some workers aren't aware of the best ways to move their investments, and common errors can trigger a big tax bill. Here is some more information about the best ways to move a 401(k) after leaving a job so you don't have to pay for unexpected taxes.

Why employees make 401(k) mistakes

Although 401(k)s are the most common type of retirement account, there are complex rules and tax penalties if workers mismanage an account. Employees make 401(k) mistakes because there are often age requirements for withdrawals, specific timelines you must follow for rollovers, and different tax rules for different types of 401(k) accounts. Without professional guidance, it's easy for workers to accidentally miss a step when moving their accounts.

Taking a lump-sum distribution

The most common 401(k) plan mistake when switching jobs is taking a lump-sum distribution and waiting too long to add the funds to a new 401(k) plan. Often, people do this with the intention of opening a new account, but miss the deadline. The IRS explains that employees have 60 days to deposit money into a new account before they're charged an early withdrawal penalty. To avoid any confusion or missing deadlines, it's best to roll a 401(k) from one account to another rather than manage the withdrawal and distribution yourself.

Why does this mistake creates a big tax bill

If employees miss the 60-day deadline and don't deposit their funds into a new 401(k) account, the IRS counts that lump-sum 401(k) balance as income. Retirement account income is taxed at ordinary income tax rates. Depending on the amount in the 401(k), the withdrawal could also push employees into a higher tax bracket. All of this together means that a big tax bill could be waiting for them once they file.

Factor in early withdrawal penalties

As mentioned, if workers receive a lump-sum distribution of their 401(k) balance and miss the 60-day deadline, that amount is taxed as income. However, workers under 59 and a half will have to pay an extra 10% early withdrawal penalty. Many workers don't realize that this penalty exists on top of the potential to be in a higher tax bracket. That's why, come tax time, employees who make this mistake may be shocked by their tax bill.

Rollovers aren't immune to tax surprises

One of the best ways to avoid these tax surprises is to roll over a 401(k) from one company to another or into a Roth IRA. However, even rollovers aren't foolproof. Sometimes, employees choose the wrong type of rollover, forget to invest rollover funds, or transfer savings into an ineligible account. Sometimes companies send a check made out to the employee's name rather than directly to the new account, which can trigger taxes.

It could take months to realize mistakes

One of the hardest parts of this common 401(k) mistake is that it might take people months to realize they made it. That's because workers might not learn about these penalties until they file their annual taxes. If workers switch jobs in the middle of the year, they likely won't know about their tax liability until they gather tax forms in the new year.

How to avoid surprise tax bills

The best way to avoid surprise tax bills is to carefully follow IRS guidelines when you're switching jobs and moving your 401(k) to a new location. This is an important task that deserves time, research, and thought. Many of these mistakes happen because workers don't realize they have options or that they have specific deadlines to meet. By consulting professionals before making a job change, like an accountant and a financial planner, workers can avoid some of these mistakes and, by extension, a surprise bill at tax time.

Bottom line

It's never a good feeling when people get a huge tax bill they weren't expecting. It's stressful and can lead to a lot of shame, especially once they realize it could be avoided. However, it's important to know that these mistakes happen because the 401(k) system is incredibly complex, with rules that change and multiple types of accounts. Therefore, the best route to take when switching jobs is to make sure you speak to a qualified professional who walks you through the proper steps to take to move your retirement plan. That way, your hard-earned money is protected, and you can retire comfortably in the future.

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